Article contributed by ACCA
How to tax payments to employees made redundant.
The taxation treatment of payments made to employees on the termination of their employment can be a tricky area in practice. It’s often not just the simple tax free £30,000 that everyone remembers. Here we take a look at the current position regarding the taxation treatment of such payments. Given that the payments can often be high in monetary value, it is important to get the tax treatment right.
The taxation treatment of a termination payment can vary, depending on the circumstances or the payment, and be either:
- fully liable to income tax and national insurance or
- taxable subject to an exemption for the first £30,000 or
- wholly exempt.
To establish the correct taxation treatment of a termination payment, all of the relevant facts surrounding the payment first need to be established. The taxation treatment can then be ascertained by working through the following steps:
The first step is to establish whether the rules relating to payments under unapproved and employer-financed retirement benefit schemes (EFRBS) apply. An EFRBS is a scheme which provides ‘relevant benefits’ on the retirement or death of an employee.
HMRC defines a ‘scheme’ very broadly and regards relevant benefits as any type of financial benefit provided by an employer on an employee’s retirement or death, other than genuine redundancy and benefits provided for disablement or death by accident during service. Such payments will therefore be fully chargeable to income tax.
Benefits in respect of ill-health or disablement of an employee during service, and benefits in respect of death by accident of an employee during service are excepted benefits and therefore are not liable to tax and national insurance.
Guidance on this area can be found in HMRC’s manuals at EIM15010 onwards.
If Step 1 is not applicable, it is then necessary to establish whether the payment is taxable as earnings from employment. A payment will be taxable and NIC-able if it is a payment for services rendered.
Payments in lieu of notice (PILONs) and compensation for loss of office payments if they are contractual, ie the employment contract provides for them, are subject to tax and NIC. Even if a payment is completely discretionary, HMRC may seek to argue that, although not paid under contract, it is part of the employer’s customary and established practice to make payments of this nature and therefore should be subject to tax and NIC.
Likewise, if the employer makes a payment in respect of a restrictive covenant, ie to restrict the future activities of the departing employee, the payment is taxable and NIC-able and PAYE should be operated accordingly.
If Steps 1 and 2 are not applicable and the payment is purely discretionary, then the payment will fall within the special rules that permit the first £30,000 to be paid free of tax and NIC by virtue of Income Tax (Earnings and Pensions) Act ITEPA 2003, s403.
To fall under s403, the payment would generally need to be either:
- made because the employment contract has been broken by the employer, or
- purely discretionary and not part of customary practice of the employer.
It should be noted that, although any statutory redundancy pay is not taxable, it does reduce the £30,000 exemption conferred by s403.
For further guidance, please refer to our Guide to Termination Payments and an article which explores the overseas aspects and deductability in employer’s accounts.
Payments and other benefits where the office or employment in question included foreign service can be either wholly exempt by virtue of ITEPA 2003, s413, or partially exempt by virtue of ITEPA 2003, s414.
The payment will be fully exempt if the employment in respect of which the payment is received included an element of foreign service constituting at least:
- three-quarters or more of the whole period of service ending with the date of the termination or change in question; or
- if the period of service exceeded 10 years, the whole of the last 10 years; or
- if the period of service exceeded 20 years, one-half or more of that period, including any 10 of the last 20 years.
The payment will be partially exempt, on a pro-rata basis, if there is an element of foreign service but none of the above limits is exceeded.
Deductibility of payments in the employer’s accounts
In order for the employer to be able to claim a tax deduction for any termination payments made, they must meet the general requirement that they were incurred wholly and exclusively for the purposes of the trade. Any statutory redundancy payment is automatically allowable but there is no special rule relating to termination payments made in excess of the statutory amount. As a general rule, it is easier to obtain a deduction for compensation payments for breach of contract, rather than a payment which is purely ex-gratia.
Where a termination payment is made on the cessation of the employer’s business, Corporation Tax Act (CTA) 2009, s79 limits the deduction in the accounts to:
- three times an amount equal to the statutory redundancy payment due.
Finally, a termination payment made to a director or shareholder can be particularly liable to attack from HMRC on the basis that it is either:
- not a deductible trading expense; or
- a distribution of profits.
ACCA UK’s Technical Advisory website provides further guidance on Income tax matters or taxation matters in general.