Although economic indicators point to the UK emerging marginally from recession, many employers are still finding they are under pressure to reduce their headcount. As such, it is useful to revisit the tax treatment of termination payments.
There is a widely held view that the first £30,000 of any termination payment is tax free. As this article will show, such a view is not necessarily correct. It is worth pointing out at this stage, that if an employer makes a termination payment and mistakenly believes that the first £30,000 is tax free, it is the employer who will be liable for any tax and/or national insurance contributions (“NIC”) it should have paid or deducted in respect of the termination payment, plus interest and penalties. Whilst this risk can be mitigated to a certain extent by limited rights of recovery against a former employee and by including a tax indemnity from the employee in a compromise agreement, there may be practical difficulties and considerable expense for the employer in enforcing the indemnity.
Termination payments are taxed under the Income Tax (Earnings and Pensions) Act 2003 (“ITEPA”). ITEPA contains a number of provisions which are potentially applicable to termination payments. It is, therefore, necessary to identify which provision is actually applicable to the termination payment in question. However, before the correct provision can be identified, the true nature of the payment needs to be determined, which will require assessing the basis on which the payment is made and considering all the background factual circumstances to the payment.
Often a termination payment will fall within more than one provision. Where this happens ITEPA states which provision is to take priority. In order to identify the correct provision, the following process should be used.
(a) Does the payment fall within the category of general earnings and as such taxable under Part 2 of ITEPA?
(b) Is the payment a taxable benefit and as such taxable under the benefits code in Chapters 2 to 11 of Part 3 of ITEPA?
(c) Is the payment for a restrictive covenant and as such taxable under Chapter 12 of Part 3 of ITEPA?
(d) Is the payment from an employer-financed retirement benefits scheme and as such taxable under Chapter 2 of Part 6 of ITEPA?
(e) If none of the above, is the payment in connection with the termination of a person’s employment and as such taxable under sections 401 to 416 (Chapter 3 of Part 6 of ITEPA) and therefore within the £30,000 exemption?
The effect of the priority provisions is that where a payment is, for example, categorised as both a termination payment and general earnings, it will be taxed as general earnings rather than a termination payment.
As mentioned, it is necessary to ascertain the true nature of the payment to establish its tax and NIC treatment because the income tax and NIC treatment of termination payments varies depending on the type of payment involved. This is particularly important as HM Revenue & Customs (“HMRC”) often challenge the nature of the payments especially where the £30,000 tax free exemption is being relied upon.
Termination payments typically take the form of one or more of the following: a payment in lieu of notice, compensation or damages for failure to serve notice, a statutory or contractual redundancy payment, compensation for a statutory employment claim (e.g. unfair dismissal, unlawful dismissal), an ex-gratia payment, retirement benefit or a benefit in kind (e.g. transfer of ownership of a company car, forgivable loans).
Clearly, where a termination payment consists of a number of different elements, it is necessary first of all to identify each of the elements and then to determine the true nature of each element.
Whilst the principles involved in determining the tax treatment of a termination payment are fairly straightforward, difficult questions are often raised in their application.
Is the termination payment taxable under Part 2 of ITEPA?
The basis of taxation under Chapter 2 of Part 2 of ITEPA is set out in section 6(1), which provides that the charge to income tax on “employment income” is a charge on “general earnings” and “specific employment income”.
The definitions of “employment income”, “general earnings” and “specific employment income” are set out in section 7. The key to these definitions is whether or not a payment constitutes “earnings”, which is defined in section 62 as:
(a) any salary, wages or fee;
(b) any gratuity or other profit or incidental benefit of any kind obtained by the employee if it is money or monies’ worth; or
(c) anything else that constitutes an emolument of employment.
It is necessary to turn to case law relating to Schedule E of the Income and Corporation Taxes Act 1988 (the predecessor to sections 6 and 62 of ITEPA), to determine what constitutes an “emolument of employment” and whether the emolument arises from employment. It is beyond the scope of this article to consider this point in detail. It should be noted though that not all payments made by an employer to an employee will constitute earnings. However, any payment made to an employee in return for “acting as or being an employee” or “being or becoming an employee” will constitute earnings. Accordingly, whether or not a payment to an employee derives from his or her employment (and as such constitutes earnings) depends on the reason why the payment is made. In general, most contractual payments (e.g. payments made pursuant to an employee’s employment contract) are liable to tax as section 62 earnings. In the Court of Appeal case of Dale v de Soissons it was held that a contractual payment stated to be compensation for loss of office (which was more akin to damages) was liable to tax as profit arising from his employment.
The most common payment made in connection with the termination of employment which does not constitute “earnings” is damages for wrongful dismissal.
Payments in lieu of notice
In practice the main difficulty that arises in respect of termination payments which are “payments in lieu of notice” (often referred to as Pilons) is whether such payments constitute “earnings” or damages. If the payment constitutes earnings, it is fully taxable. Whereas, if the payment constitutes damages, it should fall within the £30,000 exemption.
The phrase “payment in lieu of notice” is commonly used to describe at least four different types of payments:
(a) An employer gives proper notice of termination to his employee, tells the employee that he need not work until the termination date and gives him wages attributable to that notice period in a lump sum. In this case (commonly called “garden leave”), there is no breach of contract by the employer. The employment continues until the expiry of the notice and, as such, the lump sum payment is simply an advance payment of wages.
(b) The contract of employment provides expressly that the employment may be terminated either by notice or, on payment of a sum in lieu, summarily. In such a case, if the employer summarily dismisses the employee, he is not in breach of contract provided that he makes the payment in lieu. The payment in lieu is not a payment of wages in the ordinary sense, since it not a payment for work to be done under the contract of employment.
(c) At the end of employment, the employer and employee agree that the employment may be terminated immediately on payment of a sum in lieu of notice (this will invariably be the case where the employment contract does not give the employer the right to terminate summarily on payment of a sum in lieu of notice). Again, the employer is not in breach of contract by dismissing summarily and the payment in lieu is not strictly wages since it is not remuneration for work done during the continuance of employment.
(d) Without the agreement of the employee, the employer summarily dismisses the employee and makes a payment in lieu of proper notice. The employer is in breach of contract by dismissing the employee without proper notice. However, the summary dismissal is effective to put an end to the employment relationship. Since the employment relationship has ended, no further services are to be rendered by the employee under the contract. It follows that the payment in lieu of notice is not a payment of wages in the ordinary sense, since it is not a payment for work done under a contract of employment.
The tax treatment of Pilons within categories (a) to (c) above was considered in the case of EMI Group Electronics Ltd v Caldicott . Such payments are generally fully taxable as emoluments arising from employment. However, categories (b) to (d) require further consideration.
Where a Pilon is made pursuant to a contractual provision, it is taxable under section 62. It should be noted that a contractual Pilon clause may be found not just in the contract of employment, but may also be in any side letter to the main employment contract, the staff handbook, any letter of appointment, the redundancy agreement or an employer-union agreement.
Where there is a contractual Pilon clause, but the employee waives the right to notice or there is a mutual agreement to terminate early, HMRC will usually seek to tax the portion of any severance payment equivalent to the earnings for the notice period. This appears to be on the basis that there is no breach of contract and therefore the payment cannot be regarded as damages. Consequently, HMRC considers that the payment must be made under a contractual Pilon clause.
It should be noted that where an employee claims to have been constructively dismissed, it is arguable that any termination payment received by the employee is either damages for breach of contract or is a payment under the Pilon clause. If an employee actually resigns and the employer is in fundamental breach of contract, HMRC should not be able to argue successfully that payment is made under a contractual Pilon clause, as the employer, being in fundamental breach of contract, is no longer able to rely on any term of the contract. However, in such situations the employee often threatens to leave, but does not actually go, the employer then denies the breach and the parties reach a mutual agreement. In these circumstances, HMRC's view is generally that the employee has waived the breach and the payment was made under a contractual Pilon clause.
Implied contractual Pilons and “auto-Pilons”
Many employers have a custom of making Pilon payments even where there is no Pilon clause in the employment contract. Where this is the case and the employment contract in question does not contain a Pilon clause, HMRC is likely to view any Pilon as taxable under section 62 either on the basis that an implied contractual right to a Pilon has arisen or on the basis of the Pilon is an “auto-Pilon”.
Following the Privy Council case of Reda v Flag , HMRC appear to accept that it is rare for an implied term to become incorporated into a contract of employment by reason of custom and practice if it conflicts with an express obligation (e.g. an obligation to serve notice) in the contract.
However, in spite of HMRC’s views that Pilon clauses can rarely be implied, HMRC put forward a similar argument in Tax Bulletin 63 (February 2003) which it refers to as the “auto-Pilon” argument. This argument has subsequently been refined and is currently dealt with in paragraph 2777 of HMRC’s Employment Income Manual. HMRC’s argument is that where the making of a Pilon is an “automatic response to termination”, such a payment may constitute section 62 earnings. Whether or not HMRC’s auto-Pilon argument would succeed in the courts remains to be seen. However, employers are advised to avoid establishing an automatic response of making Pilons. Employers, therefore, must be able to demonstrate that each case is looked at individually, a decision is made on a case by case basis about whether to require the employee to work their notice period, to go on garden leave or to receive a payment in lieu of notice. Further if the employee is not required to work their notice period, the employer should consider the amount of the payment in lieu of the notice period and, in particular, it should consider whether to pay in full or make a deduction for any mitigation and accelerated receipt.
In the Court of Appeal case of the EMI Group Electronics Ltd v Caldicott, it was held that where a contract gives the employer a discretionary right to make a Pilon, any such payment would be taxable as an emolument from employment.
However, if the employer does not exercise its discretion to make a Pilon under the terms of the contract, but instead makes a payment of damages, the tax treatment should be different. In the Court of Appeal case of Cerberus Software Ltd v Rowley it was held that a payment made after an employee’s summary dismissal and pursuant to a decision by the Employment Tribunal, was a payment of damages, despite a right in the contract for the employer to make a Pilon. A discretionary Pilon clause does not provide the employee with a right to demand payment, it merely gives the employer the choice as to whether to make a payment in lieu of notice or not.
Whilst HMRC now accepts that in principle, damages paid following a failure to exercise a discretionary Pilon clause are taxable under section 401 of ITEPA (and therefore qualify for the £30,000 exemption), it should be noted that HMRC and the courts will critically analyse such a payment to determine whether it is a payment of damages or a payment pursuant to a Pilon clause.
Nature of the payment
Where an employment contract contains either a discretionary Pilon clause or no Pilon clause and the employer makes a termination payment, which for tax purposes is intended to be treated as damages or compensation for breach of contract, the guidelines below should be followed to reduce the risk of a successful HMRC challenge:
(a) the size of the payment should reflect the fact that there will be accelerated receipt;
(b) the size of the payment should reflect any mitigation of loss by the former employer;
(c) the size of the payment should reflect the different tax treatment of damages; and
(d) the size of the payment should reflect all the salary and benefits (as opposed to just the salary) that the former employee would otherwise have been entitled to.
Clear documentary evidence showing the reasons for making the payment and how the payment was calculated should be produced and retained.
It should be noted that the courts tend to be reluctant to find there has been a breach of contract resulting in the termination payment being treated as damages or compensation. This has recently been shown in the case of Cornell v Revenue & Customs .
A detailed consideration of the tax treatment of the other types of termination payments is beyond the scope of this article. However, it should be noted that sections 401 to 416 which deal with the taxation of payments and other benefits received in connection with the termination of employment are widely drafted and are designed to catch all payments and benefits that are not earnings and so are not taxed under section 62. Accordingly, rarely will ex-gratia payments (in excess of £30,000) escape liability to tax altogether. The first £30,000 of payments that fall within section 401 are exempt from tax and any excess will be subject to income tax in the normal way. If the payment relates to foreign service, there may be a partial or complete exemption from tax.
As previously mentioned, it should not be forgotten that sections 401 to 416 act as charging provisions on termination payments where no other charging provisions apply.
Below is a brief summary of the other common types of termination payment.
Statutory redundancy payments
Statutory redundancy payments are exempt from tax by section 309 of ITEPA.
Non-statutory redundancy payments whether contractual or non-contractual, should fall within sections 401 to 416 of ITEPA and therefore qualify for the £30,000 exemption, provided they are paid genuinely on account of redundancy and are not a form of terminal bonus.
Any payment made for restrictive covenants is fully taxable under sections 225 and 226 of ITEPA. If a former employee is required to give restrictive covenants as part of a compromise settlement, the consideration for the restrictive covenants should be set out in the compromise agreement. This is to reduce the risk of HMRC successfully arguing that a larger amount is attributable to the restrictive covenants. The consideration should be reasonable compared with the value of the rest of the package.
National Insurance Contributions
Payments that constitute section 62 earnings are subject to NIC (both employer and employee). However, payments that are liable to tax under section 401 of ITEPA are generally not liable to NIC even if they exceed £30,000.
This publication is intended merely to highlight issues and not to be comprehensive nor to provide legal advice. Conor Brindley heads up the tax group at Rosenblatt Solicitors.
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