Article by Sarah Bradford, a freelance tax author who writes extensively on tax matters. Published in the January 2002 issue of Tax Adviser. Key points
- Tax treatment of termination payments is complex
- Payments may be taxable as emoluments from employments under ICTA 1988, s. 19 or as termination payments under ICTA 1988, s. 148
- £30,000 exemption available for payments taxed under ICTA 1988, s. 148
- A termination payment may comprise several elements. It is necessary to identify the correct tax treatment for each individual component.
Termination of employment is often fraught, not least because of the inevitable emotional issues involved. However, for many, the blow of losing a job is softened by a generous termination package. Termination packages come in many guises and often what is described simply as a ‘redundancy payment’ may actually comprise several elements. For employers, this is where the fun starts. To ensure the correct tax treatment of the package of the whole, it is necessary to identify and to tax correctly each constituent part.
A typical termination payment may include redundancy pay (statutory and/or non statutory), compensation payments or damages and pay in lieu of notice. From a tax perspective, the task is to determine for each separate payment whether it is an emolument from the employment and thus properly chargeable to tax under Sch. E in accordance with Income and Corporation Taxes Act 1988 (ICTA 1988), s. 19, or whether it is a termination payment to which ICTA 1988, s. 148 applies. If it is the former, the full amount is taxable, whereas if it is the latter, a £30,000 exemption is available.
Termination payments and the £30,000 exemption
It is widely believed by those who know little about tax that the first £30,000 of any redundancy payment is tax-free. Whilst often this may be the case, it is not necessarily so. The Income and Corporation Taxes Act 1988, s. 148(1) of provides that:
‘Payments and other benefits not otherwise chargeable to tax which are received in connection with:
- the termination of a person’s employment, or
- any change in the duties of the emoluments from a person’s employment, are chargeable to tax under this section if and to the extent that their amount exceeds £30,000.’
Perhaps the most crucial words in this subsection are ‘not otherwise chargeable to tax’. If a payment is an emolument of employment taxable under Sch. E by virtue of ICTA 1988, s. 19, by definition it is ‘otherwise chargeable to tax’ and thus unable to benefit from the £30,000 exemption. So what payments fall within the scope of ICTA 1988, s. 148, rather than ICTA 1988, s. 19?
Redundancy is defined by the Employment Rights Act 1996, s. 139 as follows:
‘For the purposes of this Act an employee who is dismissed shall be taken to be dismissed by reason of redundancy if the dismissal is attributable wholly or mainly to:
This definition is adopted for tax purposes
- the fact that his employer has ceased, or intends to cease, to carry on the business for the purposes of which the employee was employed by him, or has ceased, or intends to cease, to carry on that business at the place where the employee was employed; or
- the fact that the requirements of that business for employees to carry out work of a particular kind, or for employees to carry out work of a particular kind in the place where he was so employed, have ceased or diminished or are expected to have ceased or diminish.’
Where an employee loses his or her job as a result of redundancy (as defined above) or because the task that the employee was engaged to work on has been completed, a payment may be made on termination. Such payments are usually labelled ‘redundancy’ or ‘severance’ payments and may be statutory or non-statutory.
Genuine redundancy payments are taxable under ICTA 1988, s. 148, rather than ICTA 1988, s. 19, even if there is a contractual entitlement to the payment. Consequently the £30,000 exemption is in point. It should be noted that while statutory redundancy payments are exempt from tax under Sch. E, they do fall within the scope of ICTA 1988, s. 148 and need to be taken into account when applying the £30,000 exemption. The exemption applies only once in respect of a termination and all relevant elements of the termination package should be added together before applying the exemption.
Many employers make redundancy payments under non-statutory schemes and arrangements. Such schemes and arrangements may include:
- schemes authorised by the Secretary of State as substitutes for statutory schemes and which provide for payments that are at least as high as those that would be made under statutory schemes;
- general schemes providing for payments to be made to employees who are not covered by statutory schemes (for example civil servants and National Health Service employees);
- general schemes providing payments in addition to statutory payments;
- general schemes not tied to a specific redundancy situation (for example schemes expressed in general terms that embrace redundancies as they occur; and
- schemes to meet specific redundancy situations (e.g. the imminent closure of a particular office).
The position regarding such payments is less clear-cut than for statutory redundancy payments. Only genuine redundancy payments are able to benefit from the £30,000 exemption available under ICTA 1988, s. 148. Payments made through a non-statutory scheme, which are not genuinely made to compensate for the loss of employment through redundancy, may be taxable in full. In particular, payments that may be described as redundancy payments, but that are in reality a terminal bonus, for example, payments for meetings sales or production targets or for additional work, are taxed as emoluments from the employment under ICTA 1988, s. 19 and as such are taxable in full.
The Inland Revenue have recognised that such schemes may be complex and that a single scheme may provide for a variety of payments. Consequently, employers can submit proposed schemes to their inspector of taxes for advance clearance (Non-statutory lump sum redundancy payments SP 1/94). Applications for clearance should be made in writing and be accompanied by the scheme documentation together with the text of any intended letter to employees explaining its terms.
Payments in lieu of notice
Payments in lieu of notice (PILONs) are probably one of the trickiest elements of a termination package as far as the tax treatment is concerned. The problems are due in part to the fact that ‘payment in lieu of notice’ is not a tax term and one that is used to describe a variety of different arrangements. In Delaney v Staples  1 AC 687, Lord Browne-Wilkinson identified four categories of payment that may be termed a ‘payment in lieu of notice’:
- notice is given but not worked (commonly referred to as ‘gardening leave’) and salary for the period is paid as a lump sum;
- contractual arrangements provide for payments in lieu of notice to provide as an alternative to notice;
- the employee and the employer agree at the time of the termination that the employment is to be terminated without proper notice, but on the making of a payment in lieu of notice; and
- the contractual arrangements do not provide for the making of a payment in lieu of notice. The employer terminates the contract and tenders a payment in lieu of proper notice.
The starting point in determining whether a payment in lieu of notice is taxable as an emolument from the employment under ICTA 1988, s. 19 or as a termination payment under ICTA 1988, s. 148, is the employee’s contract of employment. It is necessary to ascertain what, if anything, the contract provides and also to consider whether there are any implied contract terms or established practices under which the employee could reasonably expect payment in lieu of notice.
The Revenue’s approach to the tax treatment of payments in lieu of notice was set out in a Tax Bulletin article in August 1996 and remains valid.
Where the contractual arrangements provide for a PILON to be paid as an alternative to notice, the contract is terminated in accordance with its terms if a PILON is made instead of giving proper notice. The payment is thus a contractual payment rather than liquidated damages and is taxable in full under ICTA 1988, s. 19.
In the event that the employee and the employer agree at the time of termination that the employment is to be terminated without proper notice on the making of a PILON, then providing that there is no existing understanding in respect of that payment which could be viewed as a contractual provision or an amendment, the payment is not an emolument from employment and is taxable under ICTA 1988, s. 148.
If the contractual arrangements do not provide for the a PILON and there was noagreement or understanding that a PILON would be made, failure to give proper notice is a breach of contract by the employer and any payment made for such breach represents liquidated damages rather than an emolument from employment and as such is taxed under ICTA 1988, s. 148, rather than ICTA 1988, s. 19.
Compensation payments and damages
Payments made in compensation for loss of office are taxed under ICTA 1988, s. 148 rather than under ICTA 1988, s. 19. However, care must be taken to ensure that the payment is really a compensation payment. The nature of a compensation payment is such that the employee receives a payment instead of something that he is entitled to under his contract. This may be a payment because the contract is cancelled or because the employee gives up his contractual rights. Such payments are not from the emolument. Consequently the £30,000 exemption is in point.
Application of £30,000 limit
In applying the £30,000 limit, it is necessary to add together all the payments taxable under ICTA 1988, s. 148 and then apply the exemption. Where payments under a termination arrangement are spread over several years, any unused portion of the exemption can be carried forward.
The taxation of termination payments is complicated. The package may comprise various components, each with a differing tax treatment. To ensure the package as a whole is taxed correctly, it is necessary to identify each constituent part and tax accordingly.
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January 2002 by