It’s one of those urban myths that anyone you dismiss under the terms of a settlement agreement or make redundant can receive £30,000 tax free on departure. But what does the law really allow?
The basics
All termination payments are taxable, but there is an exemption for the first £30,000 if conditions are met. Until April 2020, if the conditions for the income tax exemption are met the whole of such a payment is NI free for the employer and employee. For payments made from 6 April 2020 the rules relating to employers’ NI will change.
Legislation
The primary tax legislation is in ss.401-403 Income Tax Earnings and Pensions Act 2003 (ITEPA) which was then added to when post-employment notice pay (PENP) was introduced in April 2018. The Income Tax (Pay as You Earn) Regulations 2003 support ITEPA . The read across to the primary legislation for NI is the Social Security Contributions and Benefits Act 1992 and the Social Security (Contributions) Regulations 2001 . The National Insurance Contributions (Termination Awards and Sporting Testimonials) Act 2019 will usher in employer-only Class 1A NI on the excess over £30,000 for termination payments from 6 April 2020.
Is it really a retirement?
Once you have an accurate breakdown of how the total package has been reached, you can begin to assess its tax and NI treatment. The first question is whether this is in fact a retirement, rather than a termination – if so is any part of the package an amount that arises from what is known as an employer-financed retirement benefits scheme (EFRB)? Essentially, this is an unregistered pension scheme. Employers often want to provide higher pension benefits than a registered scheme allows, particularly to increase pension savings if the lifetime or annual allowance has already been exceeded. If there is a payment that HMRC deems to be an EFRB, it will be fully taxable under s.394 ITEPA (but not NI’able) unless it’s no more than £100 p.a.
Pro advice. Providing a continuing benefit in kind, such as medical insurance, even for a short period also means that an EFRB has been established as a registered pension scheme can only provide benefits in the form of cash.
Ill-health or disability termination?
Recognising the special circumstances if an employee cannot work again, such payments are fully tax and NI free. As you would imagine there are tight controls as to whether the reason for the termination meets the exemption. You can read more about this exemption in Statement of Practice 10/81 , see Follow up .
What does the contract say?
Any payment that emanates from the contract such as contractual pay in lieu of notice (PILON), holiday pay or overtime will be taxed and NI’d as earnings under s.62 ITEPA .
Pro advice. Don’t try to hide contractual payments by giving them another title such as “golden handshake” or “ex gratia”. That’s not enough to make them tax and NI free.
Payment under a restrictive covenant?
A restrictive covenant is a payment you make to stop an employee doing something after they leave that could harm your business, such as poaching your customers. As this occurs “by reason of employment” it falls to be taxable and NI’able under s.225 ITEPA . After considering all the above categories what is left could be subject to the £30,000 tax exemption in s.403 and fully NI exempt until 6 April 2020.
Pro advice 1. Payments into a pension scheme on termination are non-taxable, but beware of the annual/lifetime allowances and national minimum wage.
Pro advice 2. Payment of legal costs isn’t counted as part of the £30,000 and is non-taxable.
Example payment
Let’s consider an employee who was made redundant and left immediately on 31 October 2019 with a three-month PILON. They received a termination package of £26,387. You can’t assume it’s all tax free just because it’s under £30,000 and that all of the package is NI free. The payment is made up of the following elements:
£14,437 statutory redundancy pay, £9,750 contractual PILON, £1,000 restrictive covenant and £1,200 compensation for the loss of company car during the notice period.
Scrutinising the elements of the package indicates the following: there is no early retirement payment so an EFRB has not been established. The PILON is contractual so is taxed under s.62 and is also subject to NI. The restrictive covenant is taxed in full under s.225 and subject to NI. The loss of car compensation and the redundancy can be considered as related to the termination and subject to the £30,000 exemption. So we end up with:
£10,750 which is the PILON and the covenant which are fully taxable and NI’able.
£15,637 which is the redundancy payment and the car compensation which are non-taxable and non-NI’able.
But what about PENP?
PENP
Since April 2018 we have had to consider if the PENP rules lead to a higher amount being taxed/NI’d. The rules affect any employee who has not worked all of their notice so has a PILON. Even if the PILON is contractual, so is fully taxed and NI’d as in this example, there can still be an impact. Prior to April 2018 many employers had removed PILON clauses from contracts allowing the PILON to be paid as a payment of damages for breach of contract on termination and therefore available to be considered under the £30,000 exemption, whereas a contractual PILON would always be earnings. Now that HMRC has changed the law there is no benefit in removing PILON clauses from contracts, as it’s deemed that a PILON is earnings (now known as PENP) regardless of whether the contract refers to it. To calculate the PENP in our example we need to know: the employee’s last day of employment, the length of the notice period and the basic pay for the pay period that ended immediately before the leaving date. Let’s assume our employee has sacrificed £5,000 per year into a pension so their pre-sacrifice pay is £44,000 rather than £39,000.
The PENP formula
Calculating the PENP is set out in legislation based on the formula: ((BP x D) /P) less T:
BP is the basic pay (pre-sacrifice) that the employee would have received had they continued in employment
D is the number of calendar days or months in the notice period
P is the number of calendar days in the pay period before the leaving date
T is the total amount of all the taxable elements of the termination package
In our example:
£44,000 (BP) x 90 (D) = £10,849.32
————————————————
365 (P)
Taxable termination payment (T) = £10,750
PENP £10,849 – £10,750 (T) = £99
This means we have an extra £99 that HMRC requires to be taxed. As the employee has £1,200 of car compensation that has been given as an ex gratia sum this can be “attacked” by the PENP, so the employee now receives: £10,750 taxed as earnings, £14,437 redundancy pay which is automatically non-taxable/non-NI’able and £1,200 – £99 car compensation = £1,101 tax/NI free and £99 taxed/NI’d as PENP.
From 6 April 2020 you will pay NI on termination payments that exceed £30,000, so consider terminations before then to avoid the cost. Any payment that emanates from the contract such as contractual pay in lieu of notice, holiday pay or overtime will be taxed and NI’d as earnings.
Follow up
Statement of Practice 10 (1981)