It is widely believed that the first £30,000 of any redundancy payment is tax-free. However, this is a somewhat simplistic view, as all payments received upon terminating employment are not equal.
The £30,000 exemption only applies to payments received upon terminating employment that are not payments of earnings.
Therefore, the first step in determining whether a termination package element qualifies for the £30,000 exemption (and hence is tax-free) is to determine whether the payment qualifies as an earnings payment.
How is this determined?
The term ‘payments of earnings’ generally refers to the regular payments made as part of employment. This would encompass payments stipulated in the employment contract, like wages and salary, along with customary payments that the employee anticipates receiving, even if not explicitly mentioned in the employment contract.
After termination, earnings payments are fully taxable. The £30,000 exemption is not applicable.
However, the £30,000 exemption does apply to other payments made on termination, such as to compensate the employee for the loss of his or her job or the failure to give proper notice. If the £30,000 exemption remains unused, you can make these payments tax-free.
A termination payment typically comprises a number of elements. These may include:
• Normal wages or salaries
• Payment in Lieu of Notice
• Redundancy payments
• Compensation payments, and
• Holiday pay
It is critical that each element be considered separately rather than trying to determine the payment’s tax position as a whole.
This is a case where it is necessary to look at the sum of the parts.
Wages and salaries
Wages and salaries are typical earnings payable under the employment contract. They are subject to taxation as earnings and do not qualify for the £30,000 exemption.
Payments in Lieu of Notice
The treatment of payments in Lieu of Notice (PILONs) can be tricky because the term is often used loosely to describe payments of varying characteristics. The payments’ characteristics will determine whether or not they benefit from the £30,000 exemption.
A PILON occurs when an employee receives a payment instead of their due notice. Where contractual provision is made for the making of a PILON or it is customary for a PILON to be made, HMRC regard the payment as `flowing from the employment’ and tax it as earnings, thereby denying the benefit of the exemption. However, if an employer fails to provide proper notice to an employee and pays damages for that breach, the payment does not qualify as earnings and can be tax-free up to the £30,000 limit.
People frequently mistake PILONs for gardening leaves. In a gardening leave scenario, the employee receives his normal wages and salary during the notice period without having to work his notice.
The usual taxation applies to wages and salaries. Similarly, if an employer pays off an accrued holiday, this is also considered a payment of earnings and is subject to full taxation.
Redundancy
Statutory or non-statutory redundancy payments are considered compensation payments. The good news is that you can make payments tax-free up to the £30,000 limit.
The £30,000 limit per termination applies. Only when the limit remains unsurpassed do payments qualify for exemption become tax-free. To the extent that qualifying payments exceed £30,000, these are taxable.
Practical tip
When structuring a termination package, try and make best use of the £30,000 exemption by making compensation payments rather than payments of earnings where at all possible. Care should be taken when drafting the employment contract.
By Sarah Bradford
