Termination payments are made to employees for all sorts of reasons, but the first thing to understand is that there’s no automatic entitlement to pay the first £30,000 tax–free, and if the employer gets it wrong it’s the employer who ends up paying the tax, plus interest and possibly even penalties, while the employee may walk away with more than they were really entitled to.
Nature of the payment
In fact, it isn’t only termination payments that can qualify for exemption. Compensation payments for lost employment rights that mean a change in job or status, or mean loss of future earnings, can also be tax-free up to the £30,000 maximum. However, in those cases the payment must only be compensation for a loss; if it’s in any way an inducement to continue in employment or accept a different employment it will probably still be taxable. Sounds confusing? That’s because it is, so great care is needed and it may be a good idea for the employer to get advance clearance before paying compensation; if HMRC say it’s OK, it is OK!
Statutory redundancy hardly ever exceeds £30,000 and is covered by the exemption, but additional payments can cause more difficulty. HMRC are always on the lookout for payments that are really rewards for past service but dressed up as compensation for termination. So if the employee is already entitled to a payment under their contract (e.g. under a bonus scheme for work already done) it is not possible to cancel the bonus and pay compensation instead.
Pension provision is another difficult area: almost any form of cash payment in lieu of pension provision is taxable, except in rare cases where the compensation is not for loss of pension rights already accrued and only for the loss of the right to accrue further pension in future.
Payments in lieu of notice
Payments in lieu of notice are a frequent cause of problems. They may be paid because the employee is leaving but the simple fact that employment is being terminated is not enough for the exemption to apply. There can be two catches with payments in lieu of notice: contractual notice periods and gardening leave.
The first potential catch is if the contract of employment provides that the employer has the right to terminate without notice by making a payment. This may sound like compensation for lost earnings, but the law says it’s a right under the contract that has been accrued from past service and so isn’t compensation.
The second potential catch (i.e. gardening leave or delayed termination) can also mean that compensation won’t be exempt. If the employee is put on gardening leave, his employment won’t have terminated, so payments during the period leading up to the end of service are fully taxable.
Other types of payment
Compensation may be paid for another reason connected with the termination. If the employee has been unfairly selected for dismissal, including redundancy, they may make an additional claim.
Of course, not all employments terminate with a need for compensation. When an employee leaves on the best of terms, in particular on retirement, the employer may want to recognise their loyalty and long-time diligence with an extra payment. If this is a regular practice or all employees are promised or led to believe they will receive a golden handshake, that may be taxable too, but awards due to an individual’s special qualities should fall within the £30,000 limit.
Whilst on the subject of the £30,000 threshold, we must point out that there is only one £30,000 per employment, and it covers all payments and benefits (e.g. it can include benefits–in-kind like continuing healthcare or use of a company vehicle).
Practical Tip:
Make full use of pensions - you may not be able to offer an employee who is leaving a cash lump sum, but if you want to send them off with a good retirement package consider putting an extra contribution into their pension. The contribution doesn’t eat into the £30,000 limit because it should be tax-deductible anyway, and it may enable the employee to take a tax-free lump-sum from their pension after retirement.
