Covid-19: Beware of Tax Traps with Termination Payments

Top Tip:

While redundancies are predominantly an employment law issue, the several changes to the income tax and NICs treatment over recent years mean that special attention should be paid to ensure the tax and NICs position is correct.

It is easy to think of the £30,000 tax-free exemption for termination payments and assume that all related payments are tax-free up to this amount. However, the tax rules relating to termination payments are much more complex and require an examination of what the payment is actually for in practice.

To determine the correct tax treatment, it is important to separate out each element of the payment and to consider why it has been paid, including the application of these tests:

• Is the payment linked to the employment (e.g. rewards or holiday pay) or other contractual clauses?
• Is the payment for retirement?
• Is the payment into a registered pension scheme?
• Is the payment related solely to the termination of the employment (for example, redundancy pay) or compensation for loss of office?
• Is the payment in lieu of the employee working their notice period?

If the payment is not treated as general earnings (payments made in return for the performance of services), the employer should next consider whether the payment is for a restrictive covenant; this is a payment that restricts the employee’s future conduct or activities. HMRC consider any such payments as taxable as earnings, and so income tax and Class 1 NICs would be payable on a payment for restrictive covenants.

If the payment is not for a restrictive covenant, then the employer must then consider whether the payment is made in connection with an employee’s retirement or death. This definition is quite ranging and if it applies then the payment will be treated as being from an employer financed retirement benefit scheme (EFRBS) and, as such, it is taxable as employment income and subject to income tax and Class 1 NICs.

Finally, and only if the payment is not taxable under the above rules, then it is treated as a payment made in connection with the termination of the employment and the £30,000 tax free exemption may apply.

The legislation regarding payments in lieu of notice pay (PILONs) changed in April 2018, but only for income tax purposes. Where the employment is terminated before the end of the employee’s contractual notice period, a complex calculation must be performed to determine whether any part of the payment is to be treated as Post Employment Notice Pay (PENP), which will be taxable and subject to Class 1 NICs as general earnings. Also, from 6 April 2020, the Class 1A NICs treatment follows that for income tax.

Amounts in excess of the £30,000 exemption, which are subject to income tax, are now also subject to Class 1A NICs. This means that the employer has to pay NICs on the payment, but the employee does not. This amount due should be paid through PAYE at the time the termination payment is made. This obviously increases the overall cost of a termination package that employers need to consider.

There can be a great deal of confusion about the interaction between the CJRS and redundancy. Being on furlough does not mean that an employee cannot be made redundant (and normal redundancy procedures should be followed). HMRC has made it clear that the grant cannot be used to fund redundancy payments. However, there is nothing preventing employers using the CJRS grant to fund pay while an employee is working (or on furlough for) their notice period.

During the current pandemic, redundancies are inevitable. It is important that employers are comfortable with the correct tax and NICs treatment of any payments before taking these difficult decisions and where in doubt take specialist advice.

The advice in this column is specific to the facts surrounding the questions posed.  Neither FPM nor the contributors accept any liability for any direct or indirect loss arising from any reliance placed on replies.