Tax on termination pay
Written by Ray Coman
If the termination pay is contractual it is taxable, if termination pay is compensatory it is partially exempt. Partially exempt means that the first £30,000 of the pay is not subject to income tax or national insurance. Sums received on the termination (or variation) of a contract of service are taxable where the contract provides for, or if there is reasonable expectation of, severance pay. In broad principal, pay is a reward for services. However, where an employer has breached contract by letting a staff member go before contract expiry, the payment is a compensation.
Termination pay is taxed on an employee who has resigned or has been dismissed due to gross misconduct. Payment received, following a Tribunal decision or court order, for unfair dismissal is partially exempt. A compromise agreement is a contract for the employee to renounce any claim for unfair dismissal in return for a financial compensation. Any part of the compensation which is payment in lieu of notice, payment in lieu of holiday pay or other contractual entitlement is taxable. The remaining part of pay under a compromise agreement is partially exempt.
A payment (or benefit) made to compensate an employee or office holder for the employer’s breach of contract is not made in return for services. Any non-contractual payments on termination of an employment can be regarded as compensatory in nature. Compensatory payments for redundancy or severance pay or a payment for damages in respect of an unfair dismissal is therefore partially exempt. Redundancy is treated as made if there is a change in the nature of duties. This rule is given effect by s.401 ITEPA 2003. The first £30,000 of redundancy pay is tax free. The £30,000 exemption is applied as follows:
- To cash benefits before non-cash benefits (e.g. company car.)
- To the earlier tax year, where paid in instalments over more than one tax year.
- Before foreign service. This only applies to payments before 2018/19 as foreign service exemption has been abolished.
The £30,000 exemption is reduced by statutory redundancy pay.
National insurance is payable on termination pay above £30,000 from 6 April 2019.
Where there is a prior arrangement with employee to make an ‘ex-gratia’ termination payment, it will be fully taxable under s.393 ITEPA 2003.
From 6 April 2018 there is no longer any reduction in taxable termination for a payment made in a tax year when an employee is UK resident. Prior to 2018/19, an employee could claim partial or complete exemption from tax on termination pay where non-UK resident for part of the employment.
The following payments are completely exempt from tax:
- Employer pension contributions.
- Payments in respect of termination of employment due to death, serious illness or injury of the employee.
On termination, an employer may prefer employees to ‘clear their desk’ and leave before expiry of the notice period. A payment for what would have been received for working the notice period is referred to as payment in lieu of notice. It is a contractual obligation and therefore taxed as employment earnings. From 6 April 2018, the payments are taxed regardless of whether the notice period is stipulated in the employment contract.
The employer is obliged to pay statutory redundancy pay, usually after two years of continuous service. Statutory redundancy is calculated using a formula based on age, leaving salary and length of service. Statutory redundancy pay is fully exempt from tax and NIC. The first £30,000 of non-statutory redundancy pay is also not taxable. However, this £30,000 is reduced by any statutory redundancy entitlement.
If the termination has been unlawful and the employer is required to compensate for injury to feelings, that amount of the termination pay is not taxable.
Contributions to a pension are not taxable. Where there is a significant ‘golden handshake’ payment close to the retirement of the employee, terminsation package in the form of pension can be highly tax efficient. A pension contribution helps to ‘flatten the spike’ in income – and therefore in tax- caused by a lump sum termination pay. A leaver retiring or close to retirement will have less time to wait to access cash in the pension pot. The leaver can make private pension arrangements to supplement any pension contributions made as part of the formal leaving agreement.
Payments related to injury or death are not taxed.
Outplacement consultants support a leaver with transitioning to a new career or finding a job within the same field. Often connected to outplacement is job counselling. The cost of covering an outplacement or counselling service offered as part of a termination package is not a taxable benefit. Outplacement costs do not use up the £30,000 tax exempt allowance.
Legal costs recovered from an ex-employer count towards the £30,000 limit unless the dispute has gone to court, or the costs are paid directly to the employee’s solicitor. Therefore, provided paid to the employee’s solicitor the legal cost is not treated as a taxable benefit. This is likely to occur with a compromise agreement. If the solicitor consults an accountant and includes tax advisory costs as a fee disbursement, such costs are also covered by the exemption.
A restrictive covenant is an agreement not to compete with the former employer. The issue often crops up in termination agreements as the employee poses the greatest potential threat of becoming a competitor after leaving employment. In general, payment in return for a restrictive covenant is taxable and is not covered by the £30,000 exemption. Where there is no attribution of money to the covenant, it is not given any value and is therefore not taxable. However, a covenant is sometimes given a nominal value so that it can be legally enforceable. This report does not cover employment law, however even a small payment will be subject to tax and national insurance.
Tax payable on termination payment is collected via the PAYE system. An employer is required to use an 0T tax code. An 0T tax code charges tax at the highest marginal rate. For a higher rate (40%) or top rate (45%) taxpayer, the 0T tax code will often result in too much tax being deducted at source. Let us say a taxpayer has a tax code which provides for the full personal allowance. In that case, a twelfth of the personal allowance and basic rate band is used to calculate monthly tax-free pay and monthly pay taxed at the basic rate. However, for a higher rate taxpayer, the alteration of tax code to 0T on termination pay will not take into account any entitlement to personal allowance or basic rate.
Prior to 6 April 2011, the former employer operated a BR tax code to deduct tax at the basic rate on termination pay. This often resulted in an additional tax payable for higher rate taxpayers, where pay was delayed until after issuance of P45.