Are pay-outs at the end of employment taxable?
Tax situation depends on why and when termination payment is made.
Severance payments arise in a number of different employment situations, for example, following redundancy or to settle potential tribunal claims. Employers need to understand the nature of the payment and make the correct deductions at the time to avoid future tax and national insurance liabilities, potentially including interest and financial penalties.
Whether a payment made following termination of employment is taxable or not depends on the factual circumstances. Where possible, the payment should be broken down into its constituent parts, rather than paid as a single lump sum, so the tax treatment is clear. Employers uncertain on the tax position should get advance clearance on the payment from HMRC.
Payments made up to an employee’s termination date are likely to be fully taxable. Whether payments made after this are taxable depends on which category they fall into under the Income Tax Earnings and Pension Act 2003. The nature of the payment and the context in which it is made are also important. A payment on termination is likely to be fully taxable if:
- the employee is contractually entitled to it (for example, salary or amounts paid through custom and practice)
- it is made in return for the employee agreeing to restrictive covenants
- it is in return for work carried out (including a variation of duties).
If the payment is not one of the above, then employers need to check sections 401-416 of the Act to see whether it is taxable.
Most employers are familiar with the £30,000 tax exemption which applies to payments made on termination. This includes redundancy payments, protective awards, damages for wrongful dismissal and compensation for statutory claims. If the value of the severance package exceeds £30,000 then anything over that amount will be subject to tax and national insurance in the usual way.
Whether or not notice payments are taxable can raise issues. An express right in an employment contract to pay in lieu of notice (Pilon clause) makes the payment taxable. Whether other payments in lieu are taxable depends on whether they are an "automatic response to termination" or the result of an employer exercising a discretion under an employee’s contract to make such a payment. Each case will turn on its own facts.
A severance payment may not be subject to deductions if it is:
- an injury to feelings award in a discrimination claim and is not related to termination of employment or loss of earnings.
- damages for defamation
- paid into a registered pension scheme (subject to certain conditions)
- made solely on account of injury or disability.
It can sometimes be difficult to determine what the status of a payment is, so it is important to determine what the payment is for and the reasons behind it. For example, is an agreement to make a £50,000 severance payment in three months' time an ex gratia payment or a retention payment for the employee continuing to work? If it is a retention payment, it will be fully taxable; if it is a redundancy payment, then the first £30,000 will be tax free.
The issue of whether tax was payable or not arose recently in the case of A v Commissioner for HMRC . Here a bank employee was paid £600,000 in settlement following allegations of race discrimination relating to his bonus payments. Initial correspondence from the employer suggested the payment was for shortfalls in bonuses and earnings, and HMRC took the view that the payment was earnings from employment and fully taxable. However, the tax tribunal accepted the employee's argument that the payment represented compensation (not all of which was for injury to feelings) for his threatened race discrimination claim, and was not in return for work carried out, so was not taxable.
This case should be viewed with some caution, however, as it does not seem to distinguish payments that were not for injury to feelings. This contradicts HMRC's long-held view that such payments are arrears of pay, and it is likely that HMRC will appeal.