Lump sum termination payments are regularly encountered by employers, and the income tax and national insurance contributions (NICs) treatment applied, including the operation of PAYE where appropriate, is likely to be scrutinised by HMRC during a check of an employer’s records.
Broadly, and based on current rules, the first £30,000 of a payment made in connection with the termination of employment is tax free, as long as it is not otherwise taxable as earnings. Any excess over £30,000 is subject to income tax as normal earnings, but until 5 April 2018 it is not subject to NICs. Employers are required to correctly operate income tax and NICs through PAYE on such payments via the payroll.
But getting the tax, NICs and related PAYE treatment right can be difficult because a typical termination package often consists of many different component parts, and the special rules highlighted above won’t necessarily apply to each of those parts.
Considering each component part and applying the correct tax and NICs treatment at the time of payment is, therefore, crucial to mitigate the risk of unexpected liabilities arising.
We outline six tips below to help employers avoid some common pitfalls.
1. Is the employee retiring?
A cash or non-cash payment made in connection with retirement, rather than termination of employment for other reasons, could be fully taxable as a receipt from a registered or employer-financed retirement benefits scheme. This takes precedence over the special termination payment rules outlined above.
Employers should consider whether the departing employee is close to retirement age, due to retire, or if the termination is presented to other employees as a retirement. If so, the special rules for termination payments could apply and advice should be sought.
2. Take care with payments in lieu of notice (PILONs)
PILONs can be a very complex area. A PILON is taxable and liable to NICs via the payroll under the normal rules for earnings from employment where it is provided for in the employee’s contract. But even where a PILON is not provided for in the employee’s contract, HMRC can still argue that the PILON is fully taxable and liable to NICs as normal earnings if it is paid habitually or through established practice or custom.
Employers should carefully check contracts and consider their practice and custom around PILONs to determine the correct tax and NICs treatment. Where it is determined that a payment qualifies for the £30,000 tax exemption, evidence of the checks undertaken to determine this should be retained. In those circumstances the payment is likely to be a damages payment, and a contemporaneous record of how the damages payment has been reached should be kept on file.
3. Identify payments for restrictive undertakings
Payments made to employees for entering into a restrictive undertaking (including restrictive covenants) are taxable and liable to NICs in full via the payroll. On termination, the position should be reviewed to identify whether the employee is entering into a restrictive undertaking and, if so, whether they receive a payment for entering into it. If no payment is allocated to the restrictive undertaking, the risk of HMRC arguing that all or part of the termination payment is consideration for the restrictive undertaking should also be considered.
Where the only undertaking by the employee is that they will not pursue an action against the employer concerning the termination of their employment, this would not normally be an issue unless a payment is specifically allocated to it.
4. Don’t forget other exemptions
Certain payments made on the termination of employment can qualify for special tax exemptions and reliefs.
Examples include compensation for disability, employee’s legal costs, and payments for foreign service. Employers should check that such payments meet the qualifying conditions before applying these exemptions, and in some circumstances it may be appropriate to seek HMRC clearance on the tax treatment before making the payment. It should be noted that the foreign service exemption is being abolished from 6 April 2018.
5. A report to HMRC may be due
Where a termination package is made up of cash and non-cash benefits and the total value of the termination package exceeds £30,000, a report showing the details of the termination package must be submitted to HMRC. A common example is where the value of the total termination package exceeds £30,000 and includes a continuing entitlement to employer provided private medical insurance or continuing use of a company car. In considering whether the £30,000 limit is exceeded the value of the non-cash element over the course of the period it is provided needs to be established. For example, if a company car is made available two tax years from 2017/18, the estimate of the benefit is the cash equivalent using 2017/18 rules and rates multiplied by two.
The report must be submitted to HMRC by 6 July following the tax year of payment. There is no standard return or form but the report must contain specified information.
6. Be aware that the rules are changing
The government is changing the income tax and NICs treatment of termination packages from 6 April 2018.
From 6 April 2018, all payments in lieu of notice or equivalent, regardless of whether they are contractual or not, will be taxable and liable to NICs in full as normal earnings, the foreign service exemption will be abolished, and qualifying termination payments subject to income tax on the excess over £30,000 will also be liable to employer’s NICs. Employers will need to be fully aware of these rule changes, apply the correct tax and NICs treatment and operate PAYE, as appropriate, after 6 April 2018.
RSM can support you with the tax and NICs implications of making termination payments. Please contact us for further support, advice or information.