Sarah Laing looks at the tax implications of termination payments, and redundancy payments in particular.
The term ‘termination payment’ is typically used as a generic summary for a lump sum payment, which is normally (but not invariably) made to an employee at the time the employment comes to an end. The term will encompass redundancy payments, ‘golden handshakes’, payments in lieu of notice, and a range of other similar payments.
Is it redundancy?
Whether a termination payment is taxable or not depends wholly on the nature of the payment. This is an important area but also quite a difficult one. The difficulty perhaps arises for three main reasons:
- the confusing terminology, some of which is legally defined and some used more freely;
- the interaction of tax law with employment law; and
- the interaction of different parts of the tax legislation.
Some would add a fourth complication, namely the perception – still surprisingly widespread – that everyone is entitled to receive a tax-free payment of £30,000 when they leave an employment.
The goal is normally to make a payment that is tax-deductible for the employer, that is tax free (in whole or in part – typically up to £30,000) for the employee, and that leaves the employer in a position where he is not vulnerable to any employment law challenge for wrongful dismissal or otherwise.
For tax purposes therefore, it is fundamental to establish whether the reason for an employee leaving his employment can genuinely be classed as redundancy. This is made more difficult because the tax law does not provide a definition of ‘redundancy’, preferring to pick up the definition in the Employment Rights Act 1996, s 139, which contains the following:
‘An employee who is dismissed shall be taken to be dismissed by reason of redundancy if the dismissal is wholly or mainly attributable to:
a) the fact that his employer has ceased or intends to cease:
I) to carry on the business for the purposes of which the employee was employed by him; or
II) to carry on that business in the place where the employee was so employed; or
b) the fact that the requirements of that business:
I) for employees to carry out work of a particular kind; or
II) for employees to carry out work of a particular kind in the place where the employee was employed by the employer,
have ceased or diminished or are expected to cease or diminish.’
In view of the relatively favourable tax treatment of redundancy payments, HMRC may well scrutinise any claim that such a payment has been made.
Is it taxable?
Given that the legislation (with its £30,000 exemption) does not apply to any payment or other benefit that is otherwise chargeable to income tax, the exemption will be denied if the payment could be taxed as general earnings or as an ‘amount treated as earnings’. For example, if HMRC can show that a payment is taxable as salary, as ‘money’s worth’ or as a benefit-in-kind then the £30,000 exemption will not be available.
Broadly, a payment will be fully taxable as earnings if it is a reward for past or future service by the employee. Normally, the payment will be under a contractual right; possibly, there will be merely an expectation that the payment will be made and received. It follows that if, for example, an employee is paid for a period of ‘garden leave’ (i.e. broadly still employed but not attending the workplace) then the payment will be taxable as earnings.
The strict definition of ‘earnings’ in relation to employment income encompasses:
- any salary, wages or fee;
- any gratuity or other profit or incidental benefit of any kind obtained by the employee if it is money or ‘money’s worth’; or
- anything else that constitutes an emolument of the employment.
A genuine redundancy payment is one of the few payments from employer to employee that can escape tax despite being contractual. The effect is that statutory redundancy payments are tax free up to £30,000 assuming that that exemption has not already been used to cover other payments. The amount of a statutory redundancy payment is determined under the Employment Rights Act 1996, s 162.
Practical Tip:
In practice, non-statutory payments that are genuinely on account of redundancy are also exempt (though still subject to the overall cap of £30,000 for all termination payments). The exemption applies even where there is a contractual right to the payment under the terms and conditions of the employment.
