Settlement Agreements – tax treatment tightened but not simplified
Please note that all the circumstances of the individuals must be considered and certain circumstances can affect the individual’s employment rights. For this reason, you should not rely on this article without professional advice on the facts of your case.
The tax and national insurance contributions (NICs) treatment of termination payments recently changed. There are further changes coming into force in April 2019. These changes were supposed to simplify the treatment of termination payment but in reality, it has “simply” tightened up some of the loopholes.
Employers are primarily liable to pay employer’s NICs on payments which constitute earnings from employment. And whilst there will usually be a claw-back clause in a settlement agreement which provides for employee to indemnify the employer in the event any taxes become due to HMRC, it is not advisable to rely on this for various reasons. Firstly, locating the employee may not be easy and secondly, HMRC could impose penalties for late payments which may not be covered by the claw-back clause. It is better practice to identify the termination payments which are subject to tax and NICs and make the appropriate deductions at the outset.
Payment in lieu of notice
Payments made to the employee whilst they are employed (up to the termination date) will generally be taxable. This is regardless of whether or not the payment is expressed to be compensation or otherwise. All payments in lieu of notice (PILONs) will be treated as earnings and thus taxable. This is one of the fundamental changes that came into force in April 2018. Prior to April 2018, if there was no PILON clause in a contract of employment, an employer could dress the PILON as compensation for breach of contract. This way, the first £30,000 of the PILON would not have been taxable. Since April 2018, this is no longer possible.
Now, an employer is required to “carve” out any post-employment notice pay (PENP) from any termination payment made to the employee. If an employee is working his or her notice period then a clause would simply be added to the settlement agreement to acknowledge this fact. And then, if the termination payment does not fall within the meaning of general earnings or specific employment income and is less than £30,000 there will be no income tax due.
For the majority of employees, the relevant formula will be termination pay – (basic pay x period of notice) = PENP. However, this formula could be a little more complicated if employees are not paid monthly or the notice period is not expressed in months.
It is necessary to split the termination payment into slices which are taxable and slices which are not. If the termination payment includes any elements which are taxable then the whole termination payment could become chargeable to tax.
What is and what is not taxable?
It would seem that the sensible steps to take in determining the tax due would be as follows:
1. Identify any payment which relate to unworked notice. This will include not only the basic pay but also any benefits in kind, for example, private health cover. Often, if an employee is working his or her notice, he or she would be entitled to their salary and usual benefits. Where the employer is terminating with immediate effect, the employer can make a payment equal to the benefit the employee would have received had he or she worked her notice period. Such a payment will be treated as post-employment notice pay (PENP) and will be taxable.
2. Identify all general earnings and specific employment income and carve this out of the termination payment. The definition of general earnings and specific employment income are wider than one would think. It includes non-contractual payments if the payment arises from the employment, payments which arose prior to any engagement, for example, golden hello/handshake and compensation payment in relation to the loss of shares. These payments will be taxable.
3. Determine if any payment in relation to pension contributions should be paid directly to the pension fund. Such payments would be tax-free subject to the usual allowances and not fall within the tax-free threshold covered by sections 401 to 406 of the ITEPA.
4. Analyse the termination payments and/or other payments which do not fall in the above category carefully. Termination payments will most likely be covered by sections 401 to 416 of the ITEPA. These sections have been widely drafted and is designed to catch all payments and benefits that are not earnings. Such payments will be considered an ex gratia payment and will usually benefit from the £30,000 exemption. Any payment over that threshold will most likely be subject to tax with very rare exceptions (discussed below).
Payments covered by sections 401 to 416 of the ITEPA
Any statutory redundancy payment will automatically fall within the £30,000 threshold. However, contractual redundancy payments do not. It will only fall within these sections to the extent that the payment is not treated as PENP and is a genuine redundancy payment. An example where contractual redundancy payment may be “muddied up” can be seen in the case of Hayward v HMRC . In this case, there was a clause in the contract which provided for a payment of £10,000 on termination for any reason. Logically this should include termination by reason of redundancy. However, the courts did not agree. Instead the courts treated this payment as PENP.
It is therefore crucial to specify any payment for redundancy as a payment for redundancy to fall within sections 401 to 416. Enhanced redundancy payment would most likely be considered a genuine redundancy payment but, in my opinion, only insofar as the payments have been made in the past. If there is no history of the employer making enhanced redundancy pay in a consistent manner then it could be a cause for challenge by HMRC.
Liquidated damages on breach of contract could reasonably benefit from the £30,000 exemption but it would be sensible to seek an HMRC opinion before paying it free of tax and NICs.
Options and shares are a little more complicated. The tax treatment will depend on several factors. However, and generally if a payment is made in return for the cancellation of options or to compensate for the loss of tax-advantaged options on termination then that payment will be subject to the usual income tax and NICs. It will not be covered by the £30,000 tax free threshold.
Another form of payment that should be considered would be a payment made to an employee for assisting or introducing a successful merger. Would this benefit from the £30,000 exemption? I would argue no. In my opinion such a payment is more likely to be considered general earnings or specific employment income. As such the whole amount would be taxable and it would not benefit from the £30,000 exemption. Nevertheless, it may be worth seeking an HMRC opinion for clarity.
Payments which relate to injury to feelings and the discrimination itself should be paid tax free and will normally be outside the scope of termination payment covered by sections 401 to 416 of the ITEPA. However, if the payment relates to compensation for financial loss or termination that payment is likely to be taxed as earnings. It is therefore important to ensure the description of the payment is clear in any draft settlement agreement.
Payments in relation to disability (or death or injury) may also be exempt from tax under section 406 of the ITEPA 2003. This would also be worth considering if a settlement agreement has been agreed in respect of employees on long term sickness absence. It would be prudent to obtain clearance from HMRC in this regard.
Payments made under settlement agreements are not as simple as one would expect. It is defintely worth taking the time to apportion the payments so the bulk can be paid free of tax and NICs. Getting it wrong can be costly for all parties concerned, and in particular for the employer as they are not only primarily accountable to HMRC but also because they can be subjected to penalties for and interests on late payments.