Introduction

Payments on the termination of employment, also known as severance payments or more popularly in the commercial world referred to as: Golden Parachutes, Golden Handshakes or Golden Goodbyes can take various forms. In non-litigious cases; taken at the lowest level they can be in the form of statutory redundancy payments as defined under the Employment Act 1996 or  taken at their highest level they can be in the form of significant severance or ex- gratia payments, payments out of or into a pension schemes, payments of stocks and shares and the list goes on...

In litigious cases, they may constitute damages for wrongful dismissal or breach of contract, or act as compensation for alleged unfair dismissal or for unlawful discrimination; as part of settlement agreements, they are titled ex gratia payments. Given, that many employment contracts also include non-cash benefits and consideration for restrictive covenants, the calculation of a severance package is a complex and thorny issue.

From both the employee’s and employer’s perspectives, considerations and the leveraging of the tax implications related to such payments are significant. Nevertheless, for the employee, severance payments often form the financial basis for a leap forward (and an ability to move on both psychologically and physically) to a different phase of their working career be it taking a sabbatical to taking on a new job or even starting up their own business. On the other hand, for the employer it enables them to ‘clean house’ and organise ‘clean breaks’ with certain employees without all the rigmarole and excessive burden of slavishly following long winded policy and procedures which inevitably end up in litigation if egos are not handled aright. In some cases (not all terminations are acrimonious) the employer would rather not spend more money than is necessary on an employment relation that is no longer economically viable.  All is looking Golden… or is it?

Whoever bears the taxation of all the above, it can mean the difference between a successful negotiation or eventual litigation via the High Courts or Employment Tribunals. Therefore, the tax element of settlement agreements, redundancy pay-outs or ex-gratia payments must be carefully negotiated by the legal representatives of the parties.

In this introductory article which is part of a forthcoming series on the topic – we shall provide a basic overview of the Tax Regime for the benefit of directors of small businesses (SMEs) and employees of SMEs only. However, if your circumstances are more complex you MUST SEEK SPECIALIST LEGAL ADVICE.  As we all know, Tax is never a simple affair…

Relevant Tax Legislation and governance

The main governing instrument of taxation of termination payments is the Income Tax (Earnings and Pensions) Act 2003 (ITEPA). The Act distinguishes between:

• payments taxable in full, whether paid before or after termination (Part 3); these include
  • salary payments
  • contractual bonus or commission payments
  • garden leave payments
  • consideration for restrictive covenants and
  • contractual payments in lieu of notice (PILONS)
• taxable share option exercises and vesting of other share awards (Part 7)
• Non-contractual payments in lieu of notice (s 402 B)
• Payments taxable when in excess of £30,000 (Chapter 3 of Part 6, ss 401 to 416), including.
  • damages for wrongful dismissal and payments on account of damages;
  • compensation for discrimination connected with termination;
  • non-contractual benefits in kind provided on or after termination;
  • settlements of disputed claims provided that the claim does not relate to a contractual payment such as a bonus;
  • statutory redundancy payments;
  • payments under non-statutory redundancy schemes; and unfair dismissal compensation.

The Act interacts with various other statutory measures, for instance with the Equality Act 2010. Payments on account of a physical injury or disability are tax free and free of NICS (Employers are typically responsible for the PAYE and NICS). Under s 6 (1) of the Equality Act a person  has a disability if (a) the person has a physical or mental impairment, and (b) the impairment has a substantial and long-term adverse effect on the person’s ability to carry out normal day-to-day activities. The Employment Income Manual, Statement of Practice 10/1981 in its EMI3610 also defines that employees are disabled if they  have “an incapacity to fulfil the duties and responsibilities of an office or employment … due to a sudden affliction or the culmination of a process of deterioration of physical or mental health caused by a chronic illness …”

For many years there has been a fierce discussion in case law about the taxability of compensation for injury to feelings. In Moorthy v Revenue Customs [2010] the Upper Tribunal held that payment to compensate for injury to feeling is taxable under s. 401 of ITEPA 2003. In contrast, the EAT in Timothy James Consulting Ltd v Wilton [2004] applied the s. 406 tax exemption to injury of feelings. While the Court of Appeal reversed Moorthy and confirmed that the tax exemption applies to payments to compensate for injury to feelings. The Finance (No 2) Act 2017 in its s 5(7) now blocked that lacuna and provides that payments for injury to feelings fall outside the exemption of injury payments and therefore are taxable.

All termination payments above the £30,000 threshold are subject to class 1A NICs (employer liability only); this measure has been implemented by the National Insurance Contributions (Termination Awards and Sporting Testimonials) Act 2019 and took effect on 6 April 2020.

On the same date, Regulations related to this Act came into force providing for the collection of Class 1A NICs on cash-and cash equivalent payments in real time and on benefits not reported under a PAYE scheme (P11D(b) submissions. We will expand on this in our forthcoming article.

Future trends and outlook

A new Finance Bill 2021, the draft of which was published on 21 July 2020 introduces reforms to tax administration, business rates, and a number of other areas of tax policy. In this context, amendments will also be made to ITEPA 2003 which provide for an alternative Post-Employment Pay (PENP) calculation to be used where an employee’s pay period is defined in whole months, but not their contractual notice period or post-employment notice period. In the new proposed subsection 6A to section 402D of ITEPA 2003 the new formula will no longer use the number of days in the pay period, but a formula will be inserted  which instead of using the number of days in the pay period, it provides that 30.42 (being the mean average number of days in a month) can be used as “P” in the PENP formula calculation. What impact will this have on the compensation or ex-gratia payments made to the employee? This question will be explored further during the forthcoming series…

The measure also aligns the tax treatment of PENP for individuals who are non-resident (in the year of termination of their UK employment) with the treatment of all UK residents. Both measures are part of an overall proposal to simplify taxation and aim for the removal of unintended outcomes and unfairness; and to bring clarity to this thorny issue. Thereby continuing and refining the process that begun under the very controversial Finance Act 2018.

The changes will have effect from 6 April 2021 and apply to employees who receive their termination payment on or after this date. So, as we said at the beginning, is life really going to be Golden for outgoing employees? This remains to be seen…

By Joy Douglas & Helene Albrecht– Hillary Cooper Law