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The government has published a consultation paper to consider how it can simplify the taxation and National Insurance treatment of termination payments. Schools are increasingly entering into settlement agreements with employees, which usually involve negotiating a termination payment. It is very important, therefore, to be aware of the potential tax ramifications, particularly when dealing with your auditors.
The government has suggested that there is a widespread misconception at the moment that the first £30,000 of any termination payment can be paid tax free, when in fact it will depend upon the origin of the different elements that make up the payment.
Typically, a termination payment might include outstanding salary, bonus, redundancy pay, payment in lieu of notice and compensation for waiving the right to pursue employment-related claims. The tax treatment of each of these elements needs to be considered separately to avoid the risk of an unexpected tax liability, and payments cannot simply be ‘relabelled’ to take advantage of the tax exemption. The consultation paper suggests that the current system is fraught with confusion and uncertainty and needs to be simplified.
The government is therefore considering ways to make the system fairer, simpler and easier to administer – and crucially, affordable for the Exchequer. Its proposals are:
- To remove the distinction between the tax and NICs treatment of contractual and non-contractual payments, suggesting that this will remove the majority of the misunderstanding about the current system;
- To align the tax and NICs treatment of all termination payments, so that there is no longer a discrepancy as to when both are due;
- To remove the existing £30,000 tax-free allowance and instead introduce a new, lower exemption. They have considered, but discounted, linking the tax free allowance to statutory redundancy pay (so that employee’s get a tax-free allowance which is a multiple of their statutory redundancy entitlement) on the basis that there will be some individuals who are not entitled to statutory redundancy. However, they are considering adopting a similar system, creating a new exemption which will increase proportionately with an employee’s length of service.
- To introduce a new 2 year qualifying period, so that no employee can receive a tax-free termination payment until they have accrued 2 years’ continuous service.
- Alternatively, to only allow tax and NICs relief where an employee is made redundant, suggesting that this would target relief at those who need it most. It would then introduce a new tax exemption for compensation payments for unfair or wrongful dismissal.
Although the consultation paper does not specifically confirm the level of any new exemption, it includes a worked example suggesting a tax free exemption of £6,000 after 2 years’ service, increasing by £1,000 for each additional year of service. If these proposals are implemented, it will significantly reduce the amount that most employees can receive on a tax-free basis.
The consultation paper was published on 24 July 2015 and remains open for comments until 16 October 2015.
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