HMRC plan to shake up termination payments

09 September 2015

Will tax-free termination payments become a thing of the past? Proposed changes could make it considerably more expensive to exit staff.

There aren’t many opportunities in the current tax system for employees to receive £30,000 free of income tax. There are equally a small number of occasions when employers can avoid their 13.8 per cent national insurance contribution when making a payment, however large, to an employee. But that can be the effect of the current rules on termination payments. Understandably, with such worthwhile savings to be made, the rules are very carefully policed by HMRC.

But, this is could now be set to change, as a result of suggestions by the Office of Tax Simplification (OTS).

Termination payments – the position now

Payments that an employer makes in connection with the ending of a contract of employment do not fall within the general definition of earnings from employment, but instead there is a special taxing provision that creates a tax charge. But it only applies if the payment ‘is not otherwise taxable’. So if the termination payment is really some kind of bonus, loan write-off or ‘thank you’ that would be taxable under other provisions, those other provision are applied first and it does not get near the special rules that deal with termination payments. But, if the payment escapes all other tax charges and is only caught by the termination payment rules, then those rules provide that the first £30,000 of the payment can be free of tax.

Confusingly, national insurance has its own rules and no contributions are due in respect of a termination payment, whatever its size. But, like income tax, contributions are due if the source of the payment is actually ‘earnings’ such as a bonus etc.

Case law has complicated the position further with concepts such as ‘contractual payments in lieu of notice’ and automatic compensation for dismissal, leading to disputes between employers and HMRC.

Possible changes

Following the OTS report, the Government has suggested that there should be an automatic exemption from both income tax and national insurance that applies after two years’ employment, for an amount that increases over the length of the (former) employment as long as the employee meets a definition of redundancy. This would mean the end of tax-free payments to get rid of employees quickly, without invoking formal processes. In those cases, the employee may no longer be wanted, but the role remains and so the definition of redundancy (as it currently stands and is likely to remain) is not met. This could make it considerably more expensive for employers who are used to paying-off under-performers quickly and quietly and without the bother of formal processes, to exit them from the company. Is this a price that employers can afford to pay for simplification?

Consultation on the current proposals closes on 16 October 2015; therefore we will perhaps know more in the Autumn Statement.

If you wish to discuss how these changes may impact your circumstances, please contact Bill Longe or your usual RSM adviser.