UK: Taxation of employee termination payments

The availability of the £30,000 income tax and complete National Insurance exemption for payments in lieu of notice is a common question for HR professionals. Issues generally centre on whether they are contractual payments.

A recent tax case in this area has emphasised two points:

First, the importance of considering any relevant paperwork which mentions payment in lieu of notice before forming a view on whether these exemptions are available. In this case, it was held that side agreements/ancillary documents (which can easily be overlooked) created a framework for payments in lieu of notice, which automatically made the payments fully taxable.

However, the same case has also dismissed Revenue arguments that habitual but non-contractual payments in lieu of notice (for example, where a company generally makes payments in lieu of notice, but has no contractual right to do this) are automatically fully taxable. The Revenue has been increasingly stridently arguing over the last few years that such a history of payments can make the payments fully taxable, but its arguments were dismissed in this case.

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The availability of the £30,000 income tax and complete National Insurance exemption for payments in lieu of notice is a common question for HR professionals. Issues generally centre on whether they are contractual payments.

A recent tax case in this area has emphasised two points:

First, the importance of considering any relevant paperwork which mentions payment in lieu of notice before forming a view on whether these exemptions are available. In this case, it was held that side agreements/ancillary documents (which can easily be overlooked) created a framework for payments in lieu of notice, which automatically made the payments fully taxable.

However, the same case has also dismissed Revenue arguments that habitual but non-contractual payments in lieu of notice (for example, where a company generally makes payments in lieu of notice, but has no contractual right to do this) are automatically fully taxable. The Revenue has been increasingly stridently arguing over the last few years that such a history of payments can make the payments fully taxable, but its arguments were dismissed in this case.

Tax law allows the first £30,000 of a termination payment to employees to be paid free of income tax and completely exempt from National Insurance contributions (NICs). However, the exemption does not apply if, among other reasons, payments are made as part of the terms and conditions of employment.

When considering the tax treatment of a termination payment, the question, in simple terms, often revolves around whether a termination payment is damages for breach of contract or ex gratia or a payment pursuant to the contract. Payments which the employment terms and conditions permit the employer to make (so-called contractual payments in lieu of notice or "PILONs") are common examples of contractual payments. However, there remains a large grey area, where tax law is not clear, covering payments which are not strictly provided for under a contract but where there are nonetheless prior arrangements for such payments.

SCA Packaging made a number of employees redundant on various occasions over several years. Each received a redundancy package (where the tax treatment was not disputed) and payments in lieu of notice.

Employees fell broadly into two categories.

The first category of employees were given written statements of terms and conditions when they started employment (as is required under employment legislation). These did not provide for payments in lieu of notice to be made. However, a memorandum of agreement was subsequently entered into by unions on behalf of employees, which included the words: "Payment will also be made of any unexpired period of notice as at the date of termination." Although it was made clear that each case will be decided on its particular facts, it was held in this case that this provision was incorporated into the employees' terms and conditions of employment. It was also held that this provided the employer with the mechanism to terminate the contract at the time of redundancy by agreement with the employee by means of a PILON payment for unworked notice without breaching the contract. It therefore constituted a contractual arrangement for the payment and, if the arrangement was followed on termination (here as was held to be the case) the payment was therefore fully taxable.

However, it was concluded that a second category of employees did not have these terms and conditions as part of their employment arrangements. Among factors considered were lack of awareness of the memorandum of agreement and other factors such as the frequency of reference to it. In the absence of an employer’s right to make a payment, it was therefore held that this payment was not fully taxable and so was able to benefit from the £30,000 tax and NIC exemption. The mere fact payments were regularly made to employees on termination did not automatically make them taxable.

The case is useful reading for an analysis of the factors that are considered in coming to such a view and the particular tax considerations.

The decision in relation to the first category of employees is not particularly surprising but it does show how agreeing even the mechanism for agreeing PILON arrangements in advance can cause the £30,000 exemption to be lost. When forming a view on the tax treatment of termination payments, this case demonstrates how all the underlying paperwork needs to be considered, not just the employment contract itself. PAYE audits can lead to the Revenue reading through relevant underlying paperwork - indeed when there have been a large number of terminations of employment, this is relatively routine and now increasingly thorough.

However, the decision in relation to a second category of employees (although just one employee was the subject of the actual case) will be of particular comfort for those employers who are being pressed by the Revenue to settle liabilities where they have had a policy if not a legal right to make payments in lieu. Anecdotal evidence is that the Revenue have over the past year been targeting employers who have had this policy, arguing that merely having such a policy leads to a payment automatically becoming fully taxable. The Revenue have yet to make a public pronouncement about this case or whether they will appeal, but this part of the judgment should give some comfort to those who are arguing against their views.

Case reference: SpC 541, SCA Packaging Limited v Revenue & Customs Commissioners.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 03/07/2006.