New rules will apply to employment termination payments from 6 April 2020 meaning that some settlements will be subject to NI as well as tax. With this in mind, how can you improve the tax and NI efficiency of a termination settlement?
Termination payments rules recapped
As you probably know, the rules for the taxation of termination payments changed in April 2018. Since then, although the £30,000 tax exemption continues to apply, it cannot cover a payment in lieu of notice (PILON) of any kind. A further change will take effect from 6 April 2020. Whereas currently termination payments are NI free regardless of the amount, from 6 April 2020 they too will only be exempt up to £30,000.
Note. Where a termination payment made on or after 6 April 2020 exceeds the £30,000 threshold, employers’ NI is payable on the excess (at 13.8%). Employees’ NI isn’t payable.
Tax efficiency saves costs
When negotiating a termination settlement with an employee, the more tax and NI efficient the termination payment is the better it is for both sides. Any settlement which is tax free will be worth more to the employee than an equal amount that’s taxable. Therefore, the larger the tax-free element the better.
Not limited by the exemption
If a termination settlement exceeds the £30,000 limit, it doesn’t necessarily mean that it has to be subject to tax and NI.
Tip 1. Some types of payment that would have been tax and NI free if paid to the employee while they were employed will escape any liability if paid as part of a termination settlement. For example, you could agree to provide, or continue to provide, a mobile phone for a year or two (see The next step ).
Tip 2. You can also make a tax and NI-free contribution for the former employee into an approved pension scheme. This allows for much greater tax and NI-free amounts than the benefits mentioned in Tip 1 and can be especially attractive to older employees as they will be able to access the money from the pension fund when they reach 55.
Example. Alexandra, a higher rate taxpayer, was the area manager for Acom Ltd’s retail outlets for 20 years. Following a scaling down of business in May 2020 Alexandra’s role becomes redundant. As part of a settlement agreement Acom pays Alexandra £30,000 (this doesn’t include any amount relating to her notice period). In addition Acom pays £10,000 into a personal pension plan for Alexandra. There is no tax or NI liability. Had Acom instead paid Alexandra £40,000 cash she would lost £4,000 in income tax and Acom would have had to pay £1,380 in NI contributions.
While Alexandra will be taxable on the £10,000 when she draws it from her pension savings, any growth in value until then will be tax free. Plus, 25% of whatever Alexandra draws will also be tax free. She could defer taking the pension savings until a time when she is no longer a higher rate taxpayer.
In addition to the first £30,000 of a termination payment, some benefits, e.g. use of a company-paid-for mobile phone, are tax and NI exempt. Contributions to a pension fund for the former employee are also tax and NI free. These can be especially attractive to older individuals.