Tax on Termination Payments – the devil is in the detail

In the current economic climate, many businesses are examining their cost base. Workforce costs can be significant, and are often the focus of larger-scale cost-cutting exercises. Although cutting headcount can deliver significant cost reductions, it also has immediate impact on the employees who lose their jobs.

The cost of cutting costs

Employment termination payments often arise as a result of downsizing and, with the exception of statutory redundancy pay, all other forms of payments made in connection with the loss of employment are subject to complex income tax and National Insurance Contributions (NIC) legislation. 

The tax and NIC treatment of termination payments can be very fact specific, and when an organisation has made the difficult decision to lay off staff, this may not be front of mind – this increases the potential for unexpected liabilities, penalties and reputational damage if the process isn’t managed correctly. 

For those businesses within the Senior Accounting Officer (SAO) regime, ensuring you can demonstrate an appropriate compliance process is also imperative. 

How are employment termination payments taxed?

In practice, more elements of a typical termination payment are liable to tax and NIC than not. This is often misunderstood by employers and even more often by employees. 

Since 2018, legislation has deemed payments related to the termination of employment to be “Relevant Termination Awards (RTAs)”, and we need to consider a two-step process to decide whether and to what extent an RTA is liable to tax and NIC. 

First, we need to grapple with a complex formula to calculate what is called the “Post Employment Notice Payment (PENP)”, which can require quite a long list of data. It’s important to get the PENP value correct however, as step two is to compare that to the RTA. 

Simply put, if the PENP value exceeds the full value of the RTA, then the employer is required to deduct tax and employees NICs from the termination payment via PAYE, and account for employers’ NICs. 

If the PENP value is less than the full RTA value, any excess of the RTA may qualify for the £30,000 tax relief that many are familiar with. We say “may” not “will”, because there are further complications to consider. 

If the RTA exceeds the PENP value and the £30,000 tax relief, the excess will again be subject to tax under PAYE. However, it will be liable to Class 1A and not Class 1 NICs, so there is no further deduction for the employee.

Further steps in calculating termination payments

Before you can be sure that the £30,000 tax relief is available, there are other factors to consider. 

The tax relief is only available if there are no other parts of the legislation that make the termination payment taxable first, and a liability to NICs usually arises if tax does. 

To understand the full tax position, we need to consider the makeup of the overall termination payment. There is often more than one individual element to employment termination payments, and you should look at each one in turn and establish the source of each. 

Example 

As a simple example, repeating restrictive covenants from an employment contract in a settlement agreement does not generate a tax/NIC issue, whereas adding additional covenants would make an associated payment liable to tax/NIC.  

A further complication arises if the employee is at or near retirement age, because HMRC will look at whether the payment is a form of lump sum pension payment. If HMRC takes this view, tax can potentially be levied at 45% irrespective of the tax rate the employee normally pays.  

If an employee has participated in salary sacrifice arrangements, or they are being considered as part of the settlement (e.g., paying part of the termination payment into a pension), this may not be tax free as it’s added back for PENP calculation purposes. 

If the employee has worked overseas, there are further complications. Other reliefs and tax provisions can apply that can impact to what extent the termination payment is liable to UK tax/NIC. 

It’s also important to understand whether the employee is leaving the business for good. If they return as a consultant or in some other role operating on a self-employed basis or via a personal service company, any element of the RTA that has not been subject to PAYE/NIC can be at risk. 

Accessing the £30,000 tax relief can be difficult, but there are other reliefs available that can be overlooked. For example, if the employee is suffering from ill health (physical or mental), a termination payment can potentially be completely tax/NIC free.

How we can help 

We have identified up to 63 different data points that you may need to consider for each termination payment calculation. Problems discovered after the employee has left and the relationship has ended can be difficult to put right and HMRC will inevitably approach your business to remedy any identified shortfall in PAYE and NIC. 

Therefore, wherever circumstances allow, you should aim to calculate the tax/NIC profile of a termination payment well in advance so that costs of termination arrangements are kept under control. 

Termination payments tool

Our specialist Employment Tax team has created a unique tool, developed to help employers get the tax and NIC calculations right on employment termination payments. 

The user-friendly tool is designed to analyse your termination payments and does not require any prior tax or NIC knowledge. It can deal with the complex domestic and UK elements of internationally-mobile employee termination scenarios and produces a report that can be shared with the employee receiving the termination payment.

For a demonstration of the tool and to find out about licence pricing please contact us.