Proposal to reduce the value of tax free termination payments – what you need to know

At present, termination payments comprise two elements:

• payments arising from employment or payments that the employee is contractually entitled to – which are paid subject to income tax and NICs
• payments that do not derive from employment – which do not attract NICs and are only liable to income tax on the amounts exceeding £30,000

While for many employers and those individuals that are well advised, dividing the termination payment into its taxable and non-taxable elements is not unduly complicated, the OTS experienced that many found these rules complex and time consuming to fathom out, particularly in relation to payment in lieu of notice (PILON).  In some cases, this lead to employers and employees paying additional tax following the termination date.

The OTS set out various options for reform and the Government has identified the most viable option to be to provide tax and NICs relief only where the termination payment has been made in connection with a redundancy as defined in the legislation. This proposal includes:

• creating a new tax exemption which increases proportionately with the number of years service the employee has completed
• all aspects of the termination payment would be treated the same i.e. statutory redundancy payment, ex-gratia payment for loss of employment, PILON, holiday pay
• the employee would qualify for the exemption once they have completed two years of service
• the years of service must be with the same employer or with an associated employer and would include service accumulated pre and post TUPE transfer
• there would be no difference between payments for the treatment of voluntary and compulsory redundancy

What does this mean for me?

The consultation does not suggest a proposed value for this tax exemption but a worked example uses the hypothetical exemption of £6,000 tax free payment after two years of service with an additional £1,000 tax free payment accruing for each year of additional service.  For an employee with 5 years service, they would receive the standard £6,000 exemption plus a further £3,000 for their additional 3 years service.  If the overall value of their termination payment exceeded £9,000 this would be subject to tax and NICs.

If legislated, this proposal would simplify the tax treatment of termination payments for both employees and employers.  However, if the indicative figures included in the consultation paper are anything to go by the value of the tax free payment available to all employees on termination will be drastically reduced.  One of the practical effects for employers would be to restrict the way in which employers can structure termination payments to offer tax efficiency to their employees.  Tax free payments currently act as an incentive for employees to terminate their employment and sign a settlement agreement in exchange for a tax free ex-gratia payment.  This incentive will be severely restricted.

This consultation closes on 16 October 2015 and more information can be found here.

Further information

To discuss any of the issues raised in this update or if you have any other employment and HR law queries, please do not hesitate to contact Flora Mewies.