No more £30,000 tax free settlements?

If you have ever paid a redundancy payment, entered into a settlement agreement (formerly known as compromise agreements) or negotiated a settlement of an Employment Tribunal claim, you will know that the first £30,000 of a payment of compensation for loss of employment can usually be paid free of deductions for tax and national insurance contributions (NICs). Any amount paid over £30,000 is subject to tax, but not to NICs.

The government is currently consulting on simplifying the tax and national insurance treatment of payments such as these, which they say is confusing for employers and employees and time consuming for HMRC who have to deal with queries. One key area of confusion is whether a payment in lieu of notice is taxable as earnings (including NICs) or payable free of tax (and NICs) as compensation for loss of employment.

What is proposed?

The £30,000 relief will be abolished.

Instead, there will be a new relief from tax and NICs on payments that are made to employees in connection with the termination of their employment where the employment ends through no fault of their own. The employee will need at least 2 years’ service to qualify for the relief and the amount of the relief will increase proportionately with the number of years’ service and up to a maximum amount (which has not yet been revealed). So far, this sounds to me as though the relief will apply to statutory redundancy payments and may be hard to apply to much else.

For example, if you issue an employee with a settlement agreement terminating their employment because of poor performance or misconduct you will in all likelihood need to pay tax and NICs on any compensation payment made under the settlement agreement because the employee will have contributed to their employment ending. Any attempt to dress up the reason for terminating their employment as not the employee’s fault may constitute tax fraud.

Significantly both tax and NICswill be payable on the proportion of the compensation payment which exceeds the set amount.

Is this beneficial for employers and employees?

No.

First, it will become more difficult to give an employee a tax free lump sum payment to terminate their employment under a settlement agreement unless it relates to a genuine redundancy situation. Often it is the ability to make a tax free payment that enables employer and employee to settle any potential claims and avoid going to the Employment Tribunal.

Under the new proposals, employers may need to pay a higher amount to entice an employee to sign a settlement agreement so that the employee is not impacted by the deductions for tax and NICs. Or the employee may lose out financially due to the payment of tax and NICs.

Second, any termination payments that fall outside of the new reliefs will be subject to NICs (as well as tax). This could represent a significant additional cost to employers – further increasing the cost of reaching a settlement.

Third, the government is proposing additional reliefs for compensation for unfair or wrongful dismissal or discrimination claims. However, it is not clear yet how it will be decided that a payment made to an employee relates to one of these types of claims or whether the payment is the appropriate level of compensation for these claims. The consultation asks whether the relief should be limited to awards of compensation made in Employment Tribunal proceedings. If this approach is adopted then it would be a disincentive for employees to agree to a settlement before hearing as they stand to receive less due to deductions for tax and NICs. Alternatively, an employer would have to increase the amount paid to settle a claim before hearing.

What about payment in lieu of notice? The current position:

This is currently an area of confusion.

The generally understood position is that if there is a clause in an employee’s contract of employment that entitles the employer to make a payment in lieu of notice (PILON) then that PILON is taxable as earnings (including NICs). However, in my view, this general principle extends to any agreement to make a PILON that is entered into before the employee’s employment ends.

Where there is no agreement to make a PILON in the contract of employment or otherwise before the employee’s employment ends, then the failure to give proper notice is a breach of contract and “wrongful dismissal” for which the correct compensation is the value of what would have been the employee’s wages during the notice period. In these circumstances, it is currently possible to pay that compensation free of tax (and NICs) as part of compensation for loss of employment.

The payment in lieu of notice position under the new proposals:

The guidance says that the generally understood relief for PILONs will be abolished and so any time a PILON is made it will be taxable as earnings (including NICs).

However, the guidance has also suggested that there will be a relief applicable to compensation for wrongful dismissal.

… And so the position is no clearer than the one we are currently living with as we will be left with the debate over whether a payment should be categorised as a PILON or compensation for breach of contract and wrongful dismissal.

If you’re planning any making any termination payments, watch this space for updates on tax treatment and take advice before doing so. As always, I can be contacted on 01484 821309 or at katebooth@eatonsmith.co.uk
Posted Friday 23rd of October 2015