Taxation of Termination Payments

Although economic indicators point to the UK emerging marginally from recession, many employers are still finding they are under pressure to reduce their headcount. As such, it is useful to revisit the tax treatment of termination payments.

There is a widely held view that the first £30,000 of any termination payment is tax free. As this article will show, such a view is not necessarily correct. It is worth pointing out at this stage, that if an employer makes a termination payment and mistakenly believes that the first £30,000 is tax free, it is the employer who will be liable for any tax and/or national insurance contributions ("NIC") it should have paid or deducted in respect of the termination payment, plus interest and penalties. Whilst this risk can be mitigated to a certain extent by limited rights of recovery against a former employee and by including a tax indemnity from the employee in a compromise agreement, there may be practical difficulties and considerable expense for the employer in enforcing the indemnity.

General Principles

Termination payments are taxed under the Income Tax (Earnings and Pensions) Act 2003 ("ITEPA"). ITEPA contains a number of provisions which are potentially applicable to termination payments. It is, therefore, necessary to identify which provision is actually applicable to the termination payment in question. However, before the correct provision can be identified, the true nature of the payment needs to be determined, which will require assessing the basis on which the payment is made and considering all the background factual circumstances to the payment.

Often a termination payment will fall within more than one provision. Where this happens ITEPA states which provision is to take priority. In order to identify the correct provision, the following process should be used.

Does the payment fall within the category of general earnings and as such taxable under Part 2 of ITEPA? Is the payment a taxable benefit and as such taxable under the benefits code in Chapters 2 to 11 of Part 3 of ITEPA? Is the payment for a restrictive covenant and as such taxable under Chapter 12 of Part 3 of ITEPA? Is the payment from an employer-financed retirement benefits scheme and as such taxable under Chapter 2 of Part 6 of ITEPA? If none of the above, is the payment in connection with the termination of a person's employment and as such taxable under sections 401 to 416 (Chapter 3 of Part 6 of ITEPA) and therefore within the £30,000 exemption? The effect of the priority provisions is that where a payment is, for example, categorised as both a termination payment and general earnings, it will be taxed as general earnings rather than a termination payment.

As mentioned, it is necessary to ascertain the true nature of the payment to establish its tax and NIC treatment because the income tax and NIC treatment of termination payments varies depending on the type of payment involved. This is particularly important as HM Revenue & Customs ("HMRC") often challenge the nature of the payments especially where the £30,000 tax free exemption is being relied upon.

Termination payments typically take the form of one or more of the following: a payment in lieu of notice, compensation or damages for failure to serve notice, a statutory or contractual redundancy payment, compensation for a statutory employment claim (e.g. unfair dismissal, unlawful dismissal), an ex-gratia payment, retirement benefit or a benefit in kind (e.g. transfer of ownership of a company car, forgivable loans).

Clearly, where a termination payment consists of a number of different elements, it is necessary first of all to identify each of the elements and then to determine the true nature of each element.

Whilst the principles involved in determining the tax treatment of a termination payment are fairly straightforward, difficult questions are often raised in their application.

Is the Termination Payment Taxable under Part 2 of ITEPA?

The basis of taxation under Chapter 2 of Part 2 of ITEPA is set out in section 6(1), which provides that the charge to income tax on "employment income" is a charge on "general earnings" and "specific employment income".

The definitions of "employment income", "general earnings" and "specific employment income" are set out in...