Tax on termination payments
In today’s challenging economic climate, many businesses are closely examining their expenses. Workforce costs can amount to a significant portion of budgets but can be reduced relatively quickly when necessary. If a business is considering cutting staff numbers, it is important to consider a number of payments which often arise as a result of downsizing (with the exception of statutory redundancy pay). Find out more below…
The intricacies…
Termination payments often accompany workforce downsizing. Aside from statutory redundancy pay, other payments related to employment termination are subject to intricate rules for income tax and National Insurance Contributions (NIC).
The tax and NIC implications of termination payments are highly dependent on specific circumstances. Businesses may overlook these complexities, increasing the risk of unexpected liabilities, penalties, or even reputational damage if the process is mishandled.
For companies operating under the Senior Accounting Officer (SAO) regime, ensuring robust compliance procedures for termination payments is even more critical.
How are termination payments taxed?
In most cases, termination payments are likely to attract tax and NIC. However, the rules are frequently misunderstood by both employers and employees.
Since 2018, legislation categorises payments related to employment termination as Relevant Termination Awards (RTAs). Determining their tax and NIC treatment involves a two-step process:
- Calculate the Post-Employment Notice Payment (PENP):
This step requires a detailed formula and several data points. Once calculated, the PENP value is compared against the total RTA.
- Compare PENP to the RTA:
If the PENP value exceeds the RTA, the entire termination payment becomes taxable and subject to NIC via PAYE.
If the PENP value is lower than the RTA, any remaining RTA amount may qualify for the £30,000 tax exemption—though this isn’t guaranteed, as additional factors come into play.
For any part of the RTA exceeding both the PENP and the £30,000 exemption, it will still be taxed under PAYE. However, this portion is subject to Class 1A NICs (employer-only liability), not Class 1 NICs, which involve deductions from the employee.
Other considerations for termination payments
The £30,000 tax exemption isn’t automatically available. It applies only if other legislation doesn’t make the payment taxable first. Typically, if tax is due, NIC will also apply.
Understanding the breakdown of a termination payment is crucial because payments often consist of multiple components, each with different tax treatments. For instance:
- Restrictive covenants: Reiterating existing covenants in a settlement agreement doesn’t create a tax issue. However, introducing new covenants can make related payments taxable and subject to NIC.
- Retirement considerations: Payments made to directors or employees close to retirement may be treated as lump sum pension payments. HMRC could tax these at 45%, regardless of the employee’s usual tax rate.
- Salary sacrifice arrangements: If an employee participates in such schemes or uses their termination payment to contribute to a pension, the amount may not qualify as tax-free and must be factored into the PENP calculation.
- International employees: For employees who have worked abroad, additional tax rules and reliefs may apply, affecting how much of the payment is subject to UK tax and NIC.
Another aspect to consider is whether the employee plans on returning to the company in another capacity, such as a consultant or through a personal service company. Any unpaid portion of the RTA could face further scrutiny in such cases.
While the £30,000 exemption is often the most well-known relief, there are other potential options. For example, if the employee is leaving due to ill health, the termination payment may be entirely exempt from tax and NIC.
How Price Bailey can help
Calculating the tax and NIC liabilities of termination payments can involve as many as 63 distinct data points. Identifying errors after the employee has left can be challenging, and HMRC will likely pursue the employer to resolve any shortfalls in PAYE or NIC.
To mitigate risks, employers should work with experts early in the process to ensure compliance and help control the costs associated with termination payments.
We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.
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