Navigating the complexities of parting ways with employees can be daunting. From negotiating the terms to preserving employee morale, there's already plenty to consider. But the challenge doesn't end there. Understanding how termination pay is taxed and ensuring this is accurately reflected in the legal documentation is crucial to avoid any unwelcome tax surprises.

Recent case law on termination payment

The recent tax tribunal case of L v HMRC (2024) serves as a good reminder for employers to ensure that the tax and legal implications are considered when making a termination payment.

An employee was made redundant and filed a claim to the employment tribunal for alleged discrimination, harassment, unfair dismissal, and pay inequality. A termination payment totalling around £388,000 was paid in settlement of the claims. The termination package consisted of deferred compensation and incentive awards, compensation for the termination, settlement for potential claims, and a payment for financial loss.

The employer paid the settlement amounts after deducting income tax and treating all but £30,000 of the total amount as taxable. The appellant then filed their tax return applying a different tax position, stating that the deferred compensation and incentive awards were taxable, with the tax-free sum of £30,000 deducted from this total.

HMRC opened an enquiry into the appellant’s self-assessment tax return and assessed additional income tax on the settlement payment, which was appealed.

The tax tribunal considered the tax treatment of the different components and whether:

• These components were from the employment and therefore taxable under section 62 ITEPA 2003.
• They were connected with the termination of the employment and taxable under sections 401 and 403 ITEPA 2003 (ie the special rules that provide exemption for the first £30,000).
• They fell outside the scope of taxable income entirely.

The tribunal found that the deferred compensation and long-term incentive awards, the equal pay claim, and the termination payment exceeding £30,000 should have been subject to tax. Importantly, the payment attributable to the discrimination claim was not taxable income.

This case highlights a number of key steps which are often missed in settlement negotiations:

Review the employment termination circumstances and package

It’s important for employers to fact-find and identify the circumstances regarding why the employment is ending. For example, if an employee is being made redundant, the legislation provides for certain conditions to be satisfied, and legal advice should be obtained. If an employee is being kept on for another capacity (eg as a consultant), HMRC may challenge whether there has been a genuine termination of the employment.

Careful consideration should also be undertaken to identify each element of the settlement package in order to determine the tax treatment.

As a reminder, if businesses are within the Senior Accounting Officer (SAO) regime, it is key that a process for dealing with termination payments is suitably documented and followed.

Termination payment tax treatment

The tax treatment of the termination payment depends on what is included. Some key considerations for businesses to be aware of include:

• Consider each component part: each component part of the termination package must be considered, applying the step-by-step process set out in HMRC’s guidance at EIM12810.
• PENP calculations: where an employee does not work their notice period in full and receives a “Relevant Termination Award”, a calculation is required of the Post-Employment Notice Pay (PENP). PENP is (broadly) taxable and liable to Class 1 National Insurance contributions (NIC) in the same way as ordinary earnings. The legislation provides a formula to apply, and there are a number of scenarios which add complexity to this calculation, including salary sacrifice arrangements.
• Exemptions: many employers are aware of the £30,000 exemption that can potentially reduce the income tax on termination payments, and there's a common belief that the first £30,000 of any termination payment is always free from income tax and NIC. However, the case highlighted above is a good reminder that this isn't always true. It is only available if there are no other parts of the legislation that make the termination payment taxable first. Other exemptions may also be available to explore, for example for ill-health.
• NIC: Class 1 NIC applies to contractual termination payments and PENP. Where qualifying termination payments exceed the £30,000 exemption, the excess is subject to Class 1A NIC (and tax).
• Reporting obligations: in some cases, the termination package must be reported to HMRC by 6 July following the tax year in which the termination is made.

In addition, by ascertaining the taxable status of each payment, the full severance cost can be budgeted. This should be communicated clearly to the employee to avoid any misunderstanding at the final stages of the negotiation, which can delay or even thwart a potential agreement.

Obtain legal advice on settlement agreement

It’s important to receive legal advice on the terms of the settlement agreement to ensure it supports that the correct tax treatment is applied to the payments the worker is receiving.

Clearly separating the different pay components being paid under the settlement agreement is essential. A single lump sum payment covering the termination payment, notice pay and holiday pay, for example, risks being taxed entirely as earnings. To mitigate this risk, employers should seek legal advice to ensure settlement amounts are properly worded in the settlement agreement, distinguishing between payments tied to employment and those that are not.

Additionally, ensuring the correct description is given to the payment is crucial, as this may play a significant role in determining its tax treatment. While courts, tribunals, and HMRC look beyond the labels to assess the true nature of the payment, the way it is described can influence HMRC’s conclusions, especially if the terms of the agreement are unclear. For example, “ex gratia” payments are often used in settlement agreements to describe termination payments, on the assumption that the first £30,000 of this can be paid tax-free. However, HMRC is known for challenging these payments on the grounds that they should be classified as earnings because they could instead be a reward for past service. Part of the consideration is whether the payment is considered earnings from employment or something else. This distinction will determine whether the payment is taxable as earnings.

What should employers do?

Termination packages should be reviewed from a tax and legal perspective before any payments are agreed upon and paid.

If employers have any concerns, we offer support in reviewing the payments, processes and policies. If needed, we’ll guide you through corrective actions before an HMRC review. Additionally, we provide support for handling HMRC queries and investigations.

If you have any questions or concerns about the tax or legal implications of termination payments, please contact Lee Knight, Charlie Barnes, or your regular RSM contact.