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A quick guide to taxation of termination payments

Q: When is pay in respect of a bonus not taxable? A: When it’s compensation for alleged discrimination!  A quick guide to taxation of termination payments

A tax case caught my eye this week.  No, don’t close this window and start reading the Daily Mail website “for research purposes” instead…

The case was about a banker who was paid £600k on termination of employment to settle potential claims of race discrimination.  In short, the employee in question was disappointed with his bonuses in the early 2000s.  He raised a grievance in which he alleged that he had been paid lower bonuses than others due to race discrimination.  Shortly afterwards, the employee was selected for redundancy as part of a buy-out.  He was offered and accepted a settlement agreement under which he was paid redundancy payments and £600k to settle any and all potential claims.

When asked by HMRC to explain the basis of the payments, the bank said that the discrimination allegations “held certain merit” and the £600k was to buy out the litigation risk that the case presented – the amounts were therefore effectively in respect of bonuses.  HMRC said these were taxable as earnings.  The employee appealed to the First Tier Tribunal, arguing that the sum was compensation for an intimated race discrimination claim and therefore was not taxable.  His appeal was upheld and it was confirmed that the payment was not taxable as earnings because it was compensation for a discrimination claim (which can be paid tax-free with no limit) and not in return for services.      

Frankly, I suspect this particular case itself will be of limited use to most employers for the simple reason that they are understandably averse to paying any amount by way of severance in respect of a discrimination claim.  Most do not want there to be any suggestion – even tacitly – that discrimination is admitted.  However, there may be scenarios such as this where it is difficult to present a severance payment otherwise, in which case, this case is helpful authority for how to treat such payments for tax purposes and is certainly one that employee advisors should be aware of. 

Far more often, however, I find employers looking for guidance on how to treat termination payments more generally.  As anyone who has dabbled in this area will know, determining the status of a severance payment is a dark art and if you are in any doubt, it is generally safest to seek advice from a lawyer or an accountant (not said out of self-interest!).

There are some guiding principles to bear in mind in this field which you may find helpful:

-       Payments in lieu of notice (“PILONs”) – if there is a clause in the contract of employment permitting the employer to make a PILON or this is a practice that is so common it could be said to be contractual, the payment should be subject to normal deductions in the same way as pay during employment.  If, however, there is no PILON clause in the contract and the payment could be said to be damages for breach of contract, then the employer could pay the amount tax-free.  You should, though, include an indemnity in the settlement agreement enabling the employer to pursue the employee for the tax and National Insurance Contributions (“NICs”) if HMRC decide the payment is taxable later.   Given that wrongly failing to deduct PAYE can have other consequences than the employer simply being liable for the tax and NICs, if in doubt, deduct.

-       Redundancy payments – statutory, company and discretionary redundancy payments can be made tax-free up to £30,000.  Similarly, other non-contractual payments in connection with the termination of employment (such as payment for loss of earnings in respect of an alleged unfair dismissal claim) can be paid tax-free up to this limit. Importantly, however, an individual only gets one £30,000 tax-free allowance per termination of employment so this cannot be used numerous times under different heads of loss. 

-       Restrictive covenant compensation – payments for entering into a covenant restricting what the employee can do after termination such as confidentiality, non-competition, non-solicitation/dealing with employees or clients etc should be subject to normal deductions for tax and NICs.

-       Tax-free payments – in general, employers can provide employees whose employment is terminating with the following benefits tax-free: legal fees for advice on a settlement agreement, outplacement counselling (if the employee has two years’ service or more) and re-training.  Other payments, including benefits in kind and forgiving loans can be taxable and it is always worth considering the tax consequences of offering an employee any other payment or benefit before a severance package is finalised.  Depending on the case in question, the value of non-financial benefits such as references, announcements, leaving drinks or the possibility of presenting the departure in a particular way should not be underestimated also. 

Settlement negotiations are most likely to be successful when an employer has given thought to the tax status of a possible payment or benefit at an early stage, ideally before offering it to the employee.  Equally, the opposite is true: a common cause of negotiations breaking down is when an employer has offered to make a PILON tax-free but then has to reverse this later on after realising that there is a PILON clause in the contract of employment, prompting the employee to ask for an additional sum tax-free by way of severance which the employer is unwilling to give.  Of course, securing settlement deals is by no means essential and employers would be well-advised not to use them too regularly so as not to create an expectation that one will be offered.  It is, however, helpful to make a package sufficiently attractive as to be acceptable in those cases that you want to settle and the best way to do that is to get the tax treatment right from the outset.

Right, I might just do some “research” for the rest of this afternoon….

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