Termination Payments: A Taxing Issue

Calculating the tax due on payments arising from the termination of an individual's employment can be difficult, and often causes additional complication and concern at an already challenging time for both employer and employee. The recent government consultation paper 'Simplification of the Tax and National Insurance Treatment of Termination Payments', published on 24 July 2015 and available here, seeks to address this issue and proposes the introduction of a simpler system moving forwards.

Under the current law, payments made to an employee on their termination which they are contractually entitled to (for example, contractual payments in lieu of notice) are subject to the deduction of income tax and National Insurance contributions. However, non-contractual payments on termination (generally compensation payments) can usually be paid free of tax to a limit of £30,000; thereafter only income tax will be payable.

The distinction between contractual and non-contractual payments means that each discrete element of the overall lump sum termination payment must be considered individually to assess its tax status. Various exemptions can also apply to termination payments depending on the circumstances in which they arise, further complicating the process of calculating the total payment that any given employee is entitled to.

The result is a system that the government describes in the July consultation paper as "fraught with confusion and uncertainty". Proposals have therefore been put forward to reform this area of law and replace the current system with a simplified regime that will provide greater clarity to both employers and employees. The consultation process is ongoing, but current proposals include:

• Removing the current distinction between contractual and non-contractual payments so that all termination payments are taxable, regardless of their contractual status.
• Replacing the current £30,000 exemption with a new overall exemption, which would increase in proportion to the employee's length of service to a maximum cap and would only arise after two years' service.
• Introducing anti-avoidance measures such as restricting the application of the new exemption in circumstances where the employee is resigning, a fixed term appointment is ending or the employee has agreed to a salary-sacrifice arrangement to secure a tax-free payment on termination.
• Aligning income tax and NIC rules regarding termination payments.

Although it is hoped that these changes to the system will simplify the taxation regime and provide clarity for employers and employees alike, there are also likely to be some negative consequences for employers.

Extending the regime so that all termination payments, regardless of their contractual status, are taxable, and limiting the main tax exemption to those employees with over two years' service will increase the cost of termination for employers, and will reduce the 'take-home' amount available to many employees. It is anticipated that this will have a knock-on effect in that employees will wish to secure higher settlement payments, leading to protracted negotiations and a higher risk of dismissal claims.

The government consultation period is due to close on 16 October 2015, so it will be some time before any changes are implemented, but it is anticipated that some form of change to the termination payment tax regime will be recommended.

If you require any further advice regarding the current tax regime, or termination payments generally, please contact the Ashfords Employment Team.