Employers making termination payments may inadvertently fall foul of the complex rules governing such payments. Employers must ensure they correctly identify which charging provision, if any, applies to each part of the termination package. The tax status of each element could vary significantly depending on which statutory provision applies. Employers must also consider the timing of the payment, how they differentiate between different elements of any termination package, and how to handle the new PAYE regulations.
Employers who wish to make tax-efficient termination payments must tread with care. HMRC may investigate such payments years after the event, and employers could be landed with heavy penalties and interest where payments are incorrectly accounted for.
Employers must first identify the effective termination date. This may be later than expected. Mistaking the date could lead to termination payments being taxed as ordinary employment income.
Second, employers should be aware that different charging provisions apply to different types of payment. Understanding the different provisions that could apply is crucial for both compliance and optimal planning.
Only once the relevant charging provision has been identified will it be possible to ascertain the tax and NICs status of the payment. Certain payments will be fully taxable, others partially taxed, others tax-free.
Employers should also bear in mind that the taxation of termination payments is an area of law that does not stand still. We discuss below some topical practical questions: recent case law on the differentiation between some taxable and non-taxable elements of a termination package; and the new PAYE rules that apply to payments that are made after an employee's P45 has been issued.
Identification of the termination date
Employers should be careful to identify the correct termination date, as amounts paid before that date are likely to be taxed in full. Although this seems to be a straightforward question of fact, a recent case illustrates just how particular the courts might be.
For example, in Geys v Société Générale, London Branch [2010] EWHC 648 (Ch), the employment contract was held not to have ended until the date the employer explicitly informed the employee that the employer was exercising its right summarily to terminate the contract.
The employer had previously written to the employee informing him he was summarily dismissed, and had transferred the termination payment into the employee's bank account, but, unfortunately for the employer who became liable to pay an extra sum of €2.5 million as a result, these steps were held by the High Court not to have terminated the contract.
The bank appealed and the Court of Appeal has just reversed this decision, holding that, based on the wording of the contractual documents, the contract was terminated when the payment was transferred into the employee's bank account, without any need for the employee to be specifically informed (Geys v Société Générale, London Branch [2011] EWCA Civ 307).
Charging provisions and tax treatment
ITEPA 2003 ss 401–416 (‘Payments and Benefits on Termination of Employment etc’) only come into play where no other charging provision applies. Employers must therefore first ensure that the payment is not caught by any of the scenarios shown in the flowchart.
If any of the provisions shown in the flowchart apply, there are special provisions governing tax liability, which fall outside ITEPA 2003 ss 401–416. Only after establishing that none of these provisions apply to tax a payment should the employer consider whether the payment is taxable under ITEPA 2003 ss 401–416. Payments taxable under these provisions could include:
These payments will be taxable only insofar as they exceed £30,000. They are also outside the scope of NICs, even where they exceed £30,000.
The following types of payments are completely tax free, even in excess of £30,000:
This could include payments relating to injury to feelings even where the underlying discrimination (leading to the injury to feelings) is in connection with the termination of employment and so taxed under ITEPA 2003 s 401 (Walker v Adams (Inspector of Taxes) [2003] STC (SCD) 269).
The position is less clear with regard to payments for injury to feelings where such injury is a result of the termination. Prior to Oti-Obihara v HMRC [2010] UKFTT 568 (TC), it was considered that such payments were caught by s 401 and so were taxable over the £30,000 threshold.
It was held in Oti-Obihara that payments would only be taxable to the extent they compensated for financial loss on termination of employment. Compensation payments not related to financial loss or injury to feelings might be tax-free, depending upon the circumstances, but see comments below in relation to Oti-Obihara.
Distinction between different elements of termination payment
A failure to distinguish between different elements of a termination package may lead to a less favourable outcome than where tax-free elements are clearly identified. The recent Oti-Obihara case demonstrates this in relation to injury to feelings.
While employment tribunals determining awards for injury to feelings have generally followed the guidelines in the Vento case (Chief Constable of West Yorkshire Police v Vento (no 2) [2003] IRLR 120 and Da'Bell v NSPCC [2009] UKEAT 0227/09/2809), recent case law suggests the courts may adopt a more lenient approach to apportioning termination packages between taxable and non-taxable payments.
In Oti-Obihara, a lump sum was paid to an individual who had brought proceedings against his employer for racial discrimination and harassment.
The settlement provided for the termination of his employment, the waiver of all claims against the employer, and payment of a lump sum. Following an HMRC challenge to the individual's self-assessment, the First-tier Tribunal held that the amount representing compensation for financial loss arising from termination should be identified first, and then the balance (such as compensation for discrimination not relating to financial loss in connection with termination) should be paid free of tax.
The Tribunal held that the Vento guidelines did ‘not directly relate to payments negotiated by parties’, nor to situations where ‘aggravated damages’ were warranted. The Tribunal also took account of the fact that, had the settlement not been concluded, the employee might have received damages payable under US legislation, and the fact that the employer ‘may well have been motivated to make a generous settlement to protect its reputation and to maintain privacy’.
The Tribunal's apportionment between taxable and tax-free elements of the lump sum was relatively generous to the taxpayer. Litigation may have been avoided, however, had the employer apportioned the lump sum explicitly from the outset.
Any such apportionment will need to be justified, however. HMRC are likely to strongly resist the approach taken in the Oti-Obihara case and argue that the greater part of any payment is compensation connected with termination, and so taxable under ITEPA 2003 s 401, even if it is related to matters other than financial loss.
It should also be borne in mind that Oti-Obihara was a first instance decision. While HMRC will accept that compensation for injury to feelings is exempt from tax, they are likely to contend that it is for the taxpayer to show why any payment for injury to feelings should exceed that recommended by the Vento guidelines.
Employers who are less concerned to make tax-efficient payments are under no obligation to differentiate between taxable and non-taxable elements of the termination package, unless this has been agreed in the settlement (Norman v Yellow Pages [2010] All ER (D) 272, CA).
Use of the ‘OT’ PAYE Code for post-P45 payments
From 6 April 2011, where payments are made after the P45 has been issued, employers will be obliged to deduct any tax due at 20%, 40% or 50% as appropriate, and assuming that no tax allowances are available. HMRC will require employers to withhold tax on a non-cumulative basis.
An employee paid on a month one basis will be taxed at 50% on any taxable income over £12,500, regardless of their year-round earnings. It would then be for the employee to claim back any overpaid tax.
This may lead to cash flow disadvantage for employees who under the previous rules would have had until 31 January following the end of the tax year in which payment was made to pay any additional tax due. Share based payments made after termination, will, however, continue to be subject to PAYE at basic rate only.
Employers should now be reviewing their standard compromise agreements to ensure that these do not specify withholding only at the basic rate.
Alasdair Friend, Senior Associate, Baker & McKenzie
Michael Ingle, employment tax specialist, Baker & McKenzie
