HMRCOne of the most contentious areas in the field of employment law concerns the tax treatment of settlement payments on the termination of employment. In the 20 years plus that I have been dealing with employment law matters the law in this area has never been entirely settled and there has been a long series of often contradictory decisions, such that it is possible to find a decision to match almost any chosen stance. As recently as two months ago I was writing about a decision of the First Tier Tax Tribunal which appeared to suggest that many such payments are not taxable.

Against this background, on 24 July the Government published a consultation document on “Simplification of the Tax and National Insurance Treatment of Termination Payments“. The consultation is open until 16 October and seeks views on:

  • removing the distinction between contractual (currently taxable) and non-contractual (currently generally non-taxable) termination payments and whether this will make the process easier to understand for employers and employees;
  • whether the income tax and National Insurance treatment of termination payments should be aligned;
  • which of the existing tax exemptions should be retained; and
  • whether new tax exemptions should be introduced.

Research by the Government suggests that there is a widespread but mistaken belief that the first £30,000 of any pay-off is tax free. Many employers do not understand how the current provisions should operate in practice. It is also difficult and time-consuming for employers to work out which parts of a settlement payment are tax free and which are subject to tax.

The research also suggested that the current £30,000 would probably be unaffordable if it applies to both contractual and non-contractual payments.

One potential approach referred to in the consultation is to create a new exemption which increases proportionately with the number of years worked. The minimum service requirement (to qualify for the exemption) would be two years. Qualifying service would have to be with the existing employer or continuing service including a former employer if the employee was TUPE transferred. Such exemptions might only apply in the event of redundancy, compulsory or voluntary. An example provided is that of an employee receiving a termination payment after 10 years’ service of £13,750 comprising statutory redundancy (£4750), pay in lieu of notice (£3000), an ex gratia payment of £5000 and £1000 holiday pay. If the exemption was set at £6000 after two years and then an extra £1000 for each additional year the exemption would be £14,000 and the entire payment would therefore be tax free. In contrast, if someone’s employment is terminated because of poor performance and that triggers a severance payment of £100,000, the full amount would be taxable.

The obvious problem with that approach is that it would be likely that many terminations for reasons other than redundancy would nonetheless be dressed up as redundancies in order to take advantage of the tax free exemption. Further the exemption would probably no apply to the expiry of fixed term contracts. That might therefore operate to discourage parties from entering into fixed term contracts.

It is intended that payments in respect of injury or disability will remain exempt. This must be right because such payments are in respect of damages rather than remuneration.

There may be separate exemptions (i.e. in addition to the redundancy exemption) for wrongful and unfair dismissal. The Government is supporting these exemptions because, like those for injury and disability they are compensatory in nature.

Overall, and unsurprisingly, if these reforms are introduced it is likely that employees will end up having more of their severance payments subject to tax. However, there is a lot to be said for achieving clarity once and for all, if indeed that can be achieved. One thing you can be certain of, if the rules do change then people will be out there devising structured settlements to minimise the tax liability as soon as they are introduced.