It’s £30k tax-free; right? This is probably the question that comes up most when a business is considering reducing its workforce. The short answer is “no”.
Whether or not the UK will fall into recession, sadly, many organisations are already considering options for reducing headcount. So, it’s timely to revisit the tax and national insurance contribution (NIC) rules for termination payments.
Stages of the calculation
Since 2018, legislation has deemed payments related to the termination of employment as “Relevant Termination Awards” (RTAs), and there is a two-step process to decide whether, and to what extent, an RTA is liable to tax and NIC.
First, we need to grapple with a complex formula to calculate what is called a Post Employment Notice Payment (PENP), and that necessitates a long list of data. It’s vital however, as once we have a PENP value, step two is to compare that to the RTA.
If the PENP value exceeds the full value of the RTA, then an employer has to deduct tax and employees’ NICs from the payment via Pay As You Earn (PAYE), and also account for employer’s NICs. However, if the PENP value is less than the full RTA value, any excess over the PENP may qualify for the £30,000 tax relief that many are familiar with – see below.
If the RTA exceeds both the PENP value and the £30,000 tax relief, any excess will be subject to tax under PAYE. However, it will be liable to Class 1A and not Class 1 NIC, ie additional employer NICs but no further deduction for the employee.
What about payments in lieu of notice (PILONs)? While they may still feature in a termination payment, since 2018 they have been liable to PAYE/NIC – unless the PILON is paid as damages.
Does the £30,000 relief apply?
While the £30,000 tax relief may be available in some cases, there are a number of factors to consider to be certain: as a rule of thumb, it is only available if there are no other parts of the legislation that make the RTA taxable first.
To navigate this legislative maze, it’s important to know how the overall RTA is made up. It is common for there to be several individual elements, and it’s necessary to look at each one in turn to establish its source. For example, repeating restrictive covenants from an employment contract in a settlement agreement does not generate a tax/NIC issue, whereas adding additional covenants would make an associated payment liable to PAYE/NIC.
Further complications arise if the employee is at or near retirement age. HMRC will look at whether the payment is a form of lump-sum pension payment, and if it takes this view, tax can be levied at up to 45%.
It’s also important to understand whether the employee is leaving the business for good. If they return in a role operating on a self-employed basis, or via a personal service company, any element of the RTA that has not been subject to PAYE/NIC can be at risk. The disposal of any shares or share options that are related to employment at the time of termination requires careful consideration.
Accessing the £30,000 tax relief can be difficult, but there are other reliefs available with termination payments that shouldn’t be overlooked. Correctly structured, payments made directly into a pension (subject to the usual contribution limits) can be made free of tax/NIC as part of a termination payment. Also, if the employee is suffering from ill health (physical or psychological) an RTA can potentially be completely tax/NIC free. There is also potential relief if discrimination has taken place and part of the RTA relates to an award for injury to feelings. Since April 2018, there is no relief related to foreign service for termination payments, however, if the employee is not UK tax resident when the RTA is made, the impact of the relevant double tax treaty will need to be considered to assess which country has taxing rights.
When a termination payment is paid, the situation can often be time-constrained and tense, and decisions are made under pressure. However, making mistakes in taxing termination payments can prove expensive for both the business and the employee, and they are often fertile ground for HMRC enquiries. Getting an expert tax opinion before payments are agreed is a sensible approach.