Amendments to the PAYE Regulations in effect from 6 April 2011 mean that the perfectly legal “trick” of deducting only basic rate PAYE from termination payments made to departing (or more accurately recently departed) employees who are higher rate tax payers will no longer work.
Currently where a payment to an employee is deferred until after he or she has left the employment in which they were employed, the employer has to deduct tax at the basic rate only, using PAYE code BR. This is because the payment will not be included on the individual’s P45. The result is that higher-paid employees may not pay enough. Of course they have to pay in due course but not until after their tax return for the year has become due. This can give a substantial cash-flow advantage to higher paid ex-employees who can thus have interest free use of the postponed tax, sometimes for many months.
From April 2011 the employer has to operate code 0T instead of code BR, so that affected ex-employees will pay tax upfront at the basic, higher and additional rate as appropriate. Tax code 0T is a “worst case” code: it does not allow for any personal allowances and requires deduction of tax on a non-cumulative (Week 1/Month 1) basis.
In some cases it may well be that this will result in more tax being deducted than eventually turns out to be appropriate. In that case the employee will have to reclaim the overpaid tax later.
It is worth stressing that this is “merely” a change in PAYE coding, effectively meaning that the change is a cash flow change rather than a change of substance. In particular the exemption from tax for the first £30,000 of compensation paid on termination of employment which can apply in many cases is not changed.
It is also worth noting that the effect of the new rules can be mitigated if the termination payment is made under contractual terms which provide for payment by monthly instalments. This is because in that case each instalment will be taxed separately. Depending on the amounts involved, it may be possible to work out a system where only basic rate tax is payable under Code 0T on each monthly instalment even though the cumulative total of the instalments will mean that the ex-employee is a higher rate taxpayer.