Employers: Tax and Termination Payments

"What are termination payments?" I hear you ask.

Well termination payments are severance payments made to employees on termination of their employment. They can arise in a number of ways, for example:

• In the event of their dismissal (or constructive dismissal);
• Redundancy;
• Retirement;
• Departure because of medical reasons.

Quite often under the circumstances neither the employer or the employee pay sufficient attention to the tax implications of termination payments, as the focus is normally on securing the best possible terms for settlement.  This means that both parties often 'miss a trick' as the correct tax structuring can result in a higher "net" payment for the employee, and vice-versa a lower "gross" payment for the employer.

"Why do employers need to know about the taxation of termination payments?" you ask "Surely any tax due is the liability of the employee."

Well, termination payments must be taxed correctly by the employer as HM Revenue & Customs (HMRC) can recover unpaid tax, national insurance contributions (NICs), penalties and interest from the employer! Consider both income tax and National Insurance Contributions (NICs). In addition to employee's NICs, employers have to pay employer's NICs on payments that constitute earnings from employment. This can significantly add to the costs of settlement.

If an employer does not deduct tax or NICs from a termination payment, it is, generally, liable for the tax and NICs not deducted, plus interest and penalties.

Both the employer and former employee will want the termination payment to be legitimately structured to reduce the tax liability and will also want certainty that no future tax liability will arise. How much of a termination payment is taxable will depend on the nature and amount of the payment. Accordingly, it is important to ascertain why the payment is being made and all the background facts.

Payments usually fall into a number of defined categories, including:

• Sums that the employee was contractually entitled to or which relate to past or future service. These are generally taxable in;
• Consideration for entering into restrictive covenants. This is taxable in full also;
• Payments where termination results from a disability or from a discrimination claim not connected to the termination. These are tax-free without limit;
• Share options and share awards. Employees may be entitled to exercise share options and receive share awards either before or at some point after termination;
• Employer contributions to registered pension schemes. These may be made tax free subject to the annual allowance and lifetime allowance limits.

NICs are generally payable for all termination payments that the employee is entitled to under the employment contract. HMRC may argue that NICs are payable where there is an established practice of making termination payments, even where there is no express contractual right.

There are also certain tax-free benefits can be provided to employees upon termination, and provided that payment is made directly to the provider of the service, the following services can be made available to the employee without attracting tax:

• Legal fees in connection with the settlement agreement;
• Outplacement counselling;
• Re-training.

The taxation of termination payments is a complex topic and this blog post is only a brief overview. For more information please contact me at HCB Solicitors Ltd to discuss your personal circumstances.