Navigating the complexities of employment termination can be challenging for both employers and employees. Termination payments play a crucial role when employees face redundancy, resignation, dismissal, or negotiation of a settlement agreement. These payments may consist of various components such as accrued holiday pay, bonuses, payment in lieu of notice (PILON), restrictive covenant payments, continued benefits, and compensation for loss of employment.
Understanding the tax implications, legal considerations, and recent case law surrounding termination payments is essential to ensure compliance and avoid disputes with HMRC.
Types of termination payments
Accrued holiday pay
Employers are legally required to compensate employees for any accrued statutory holiday not taken before termination. Payment in lieu of holiday is only permitted upon termination. If an employment contract provides for additional holiday entitlement beyond the statutory minimum, it should specify the treatment of accrued contractual leave upon termination.
Payment in Lieu of Notice (PILON)
Most employees with at least one month of service are entitled to a notice period, usually stipulated in their contract. Unless termination is due to gross misconduct, which nullifies notice pay, employers can opt to pay PILON instead of requiring employees to serve their notice period. PILON payments are subject to income tax and National Insurance contributions, akin to regular salary.
Redundancy payments
Employees with at least two years of continuous service are entitled to statutory redundancy pay, calculated based on their work history, age, and wages. Redundancy payments up to £30,000 are generally tax-free. However, any additional redundancy compensation beyond statutory entitlement is taxed as general earnings.
Compensation for loss of employment
Termination-related compensation may be exempt from National Insurance contributions and taxed only if exceeding £30,000. However, the classification of payments can be complex, as benefits may take various forms. Ensuring proper structuring of payments is crucial to securing tax exemptions where applicable.
Tax implications of termination payments
Tax-free allowance and Post-Employment Notice Pay (PENP)
Termination payments may be tax-free up to £30,000, provided no contractual obligation dictates otherwise. The Post-Employment Notice Pay (PENP) ensures that payments resembling salary - such as PILON - are taxed appropriately and do not benefit from the £30,000 exemption.
Taxable components
Certain elements of termination payments are taxable, including:
Unpaid wages
Holiday pay
Bonuses
PILON
Payments linked to restrictive covenants
Severance pay exceeding £30,000
Exemptions
Some termination-related payments are tax-exempt, such as:
Employer contributions to a registered pension scheme
Legal fees paid directly to an employee's solicitor
Payments due to injury, illness, or disability preventing continued employment
National Insurance Contributions (NIC)
Contractual termination payments and PENP are subject to Class 1 NIC. Any qualifying termination payments exceeding £30,000 are liable for Class 1A NIC and income tax.
Legal Considerations
Settlement Agreements
Settlement agreements (previously known as compromise agreements) are mutual agreements between employers and employees to resolve potential claims. They typically include payments for statutory redundancy, wrongful dismissal, and compensation for discrimination. Proper structuring of settlement agreements is vital to ensuring correct tax treatment and avoiding disputes with HMRC.
Protected Conversations
Employers and employees may engage in "protected conversations" to discuss termination terms without the risk of these discussions being used in legal proceedings. This differs from "without prejudice" discussions, which apply only when an existing dispute is being settled.
Case Law: L v HMRC (2024)
A recent tax tribunal case highlights the importance of considering tax implications in termination settlements. An employee who was made redundant and filed claims for discrimination and unfair dismissal received a £388,000 settlement. The tribunal ruled that deferred compensation, incentive awards, and equal pay-related payments were taxable, while payments specifically for discrimination were not.
Confidentiality and Non-Disclosure Agreements
The tax treatment of non-disclosure-related compensation can be complex. In a recent case, Mrs A v HMRC [2022] UKFTT 421, a tribunal ruled that payments tied to confidentiality agreements were taxable as restrictive undertakings, regardless of whether they directly related to employment duties.
Practical steps for employers
1. Review employment termination circumstances
Understanding the reason for termination helps ensure compliance with statutory requirements. For instance, redundancy must meet specific legal criteria.
2. Consider each component of the package
Employers should assess all termination package components, including:
Deferred compensation
Incentive awards
Compensation for termination
Any other contractual payments
3. Seek legal advice
Employers should obtain legal counsel to:
Ensure proper wording of settlement agreements
Accurately classify and document payment components
Mitigate risks of incorrect tax treatment
4. Communicate clearly with employees
Providing employees with clear breakdowns of their termination package prevents misunderstandings. Employers should explain which components are taxable and ensure transparency in negotiations.
5. Report to HMRC
Certain termination payments must be reported to HMRC by July 6 following the tax year in which termination occurs. Accurate reporting is essential to avoid tax liabilities and potential penalties.
Termination payments require careful planning to ensure compliance with tax laws and employment regulations. Employers should classify payments correctly, seek legal advice, and maintain clear communication with employees to avoid tax disputes. Recent case law underscores the importance of these considerations. By following best practices, businesses can navigate termination payments effectively while minimising risks and financial liabilities.
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