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The vexed question of how to tax termination payments – consultation on reform

The current rules on the taxation of termination payments have been around for many years. However, given their complexity, they frequently cause confusion and often lead to inadvertent errors for employers trying to comply with them.

With the aim of simplifying the system and creating certainty over tax status, HM Revenue and Customs (HMRC) is now consulting on possible changes to the taxation of termination payments. The proposals could include replacing the existing £30,000 exemption from income tax and National Insurance Contributions (NICs) with a new exemption for redundancy payments only which increases proportionately with an employee’s length of service.

Current position and the proposals

At the moment, generally, all elements of a termination payment to which an employee is contractually entitled are subject to income tax and NICs in the usual way. Conversely, no NICs are payable on the elements of a termination payment that are made in connection with termination of employment and such payments are only liable to income tax on the amounts exceeding £30,000. Payments in lieu of notice (PILONs) can be taxable and subject to NICs or tax and NICs free depending on whether there is a PILON clause in the employment contract. Even if there is no PILON clause, some PILONs (known as auto PILONs) may still be taxable if the employer has a policy of making them to leavers. As termination payments are often made up of several different elements, these rules can result in difficulties for employers in determining which parts are taxable and subject to NICs.

HMRC is therefore considering the following options for reform:

- Removing the distinction between the tax and NICs treatment of contractual and non-contractual payments so that (as a starting point) all termination payments are taxable and subject to NICs. This proposal would remove the difference in treatment of contractual and non-contractual PILONs which is the subject of widespread confusion;

- Aligning the income tax and NICs treatment of termination payments;

- Changing the fixed £30,000 exemption to an amount which increases proportionately with the number of years of service which will, for most, result in a significantly reduced exemption;

- Introducing a two year qualifying period of service for the tax and NICs exemption;

- Tying the tax and NICs exemption to genuine redundancy situations only. If HMRC proceeds with this approach, two new categories of exemptions would be introduced for payments made in connection with wrongful or unfair dismissal and for compensatory payments made in discrimination cases;

- Introducing a rule that payments would become taxable and liable to NICs if the employee is re-engaged to do a similar job for the same or an associated company within a 12 month period.

Potential consequences

Whilst the consultation paper does not set out a specific level of exemption, it includes a hypothetical example which refers to a £6,000 tax and NICs exemption after two years’ service increasing by £1,000 for each additional year of service. If the government were to implement its proposals at this level, it will mean a significantly reduced tax-free sum for almost all employees on termination.

Some of the proposals including the exemption increasing with length of service and only being available for redundancy situations would be a radical departure from the current system. Given that genuine termination payments are at present not subject to NICs at all and only taxable to the extent that they exceed £30,000 regardless of the circumstances of termination, the proposals would in many cases push up the costs of termination for employers.

Simplification or a tax grab?

Although HMRC is consulting on its proposals, it seems inevitable that the current system will be overhauled and employers and employees alike will have to accept any reforms just as we have to for changes to the rules on personal taxation.

Whilst simplification is welcome in itself, the current tax free threshold does play a part in helping to resolve employment disputes, mitigating the burden on public finances caused by unemployment and reducing the financial hardship of redundancy. By significantly reducing the £30,000 exemption HMRC will have the benefit of a miniscule increase in tax revenue but at the potential cost of a rise in both employment tribunal disputes and the cost to the public purse of unemployment.

Interested parties are invited to respond to the consultation by 16 October 2015. The consultation paper can be found here:

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Legal news, views, trends and tools for HR Professionals. Stay ahead. Go further