While redundancies are predominantly an employment law issue, the several changes to the income tax and NICs treatment over recent years mean that special attention should be paid to ensure the tax and NICs position is correct.
Determining the tax treatment of termination payments
It is easy to think of the £30,000 tax-free exemption for termination payments and assume that all related payments are tax-free up to this amount.
However, the tax rules relating to termination payments are much more complex and require an examination of what the payment is actually for in practice.
As a starting point, employers should assume that the termination payment is subject to tax and NICs unless there is a certain exemption.
To determine the correct treatment, it is important to separate out each element of the payment and to consider why it has been paid, including the application of these tests:
- Is the payment linked to the employment (e.g. rewards or holiday pay) or other contractual clauses?
- Is the payment for retirement?
- Is the payment into a registered pension scheme?
- Is the payment related solely to the termination of the employment (for example, redundancy pay) or compensation for loss of office?
- Is the payment in lieu of the employee working their notice period?
The tax and NICs treatment of each element of the payment will be determined by the answers to these questions.
When considering the tax treatment of a termination payment, the starting point is whether the payment, or any element of it, should be treated as earnings from the employment.
This will include any payments that are made to employees in return for the performance of services.
If this is the case, the payment will be treated as general earnings and subject to income tax and NICs. An example might be a bonus payment or commission.
If the payment is not treated as general earnings, the employer should next consider whether the payment is for a restrictive covenant; this is a payment that restricts the employee’s future conduct or activities.
HMRC consider any such payments as taxable as earnings, and so income tax and Class 1 NICs would be payable on a payment for restrictive covenants.
If the payment is not for a restrictive covenant, then the employer must then consider whether the payment is made in connection with an employee’s retirement or death (under section 394 ITEPA 2003).
This definition is quite ranging and if it applies then the payment will be treated as being from an employer financed retirement benefit scheme (EFRBS) and, as such, it is taxable as employment income and subject to income tax and Class 1 NICs.
There are certain limited exemptions but they are unlikely to apply in these circumstances.
