The taxing question of Termination Payments

What do bursars need to know about the taxation of payments to employees on the termination of their employment?

Bursars will be familiar with Settlement Agreements and the COT3 agreed through ACAS to record financial compensation linked to the settlement of employment related claims.  In the majority of cases the financial arrangements are straightforward; however a flurry of activity in the Courts recently intended to clarify the taxation of some types of termination payments may challenge existing perceptions. 

At the same time HMRC has led a consultation on proposed changes to the system for deducting tax and NICs from termination payments with findings due out soon. Proposals for reform include removing the distinction between contractual and non-contractual payments (so all payments made in connection with the termination of employment would be subject to income tax and National Insurance Contributions (NICs)), aligning the income tax and NIC treatment of termination payments and introducing a new exemption from tax and NICs.

So what are termination payments?

Termination payments are severance payments to employees on termination of their employment for any reason.

• To reduce the tax liability and increase the certainty that no future liability will arise.

• HMRC can recover unpaid tax, NICs, penalties and interest from the employer if termination payments are not taxed correctly. It is not always easy to recoup sums recovered by HMRC from an ex-employee even when there is an indemnity in place in favour of the employer.
• An employer should consider the cost of and NICs.  In addition to employee's NICs , the employer must pay employer's NICs on payments that constitute earnings from employment.  This can add significantly to the cost of settlement.

Employers should clearly set out the grounds for payment in the Settlement Agreement or COT3. If an element of the payment represents damages for injury to feelings arising from an alleged detriment or act of discrimination suffered before, and separate to, a dismissal this should be spelled out to demonstrate to HMRC under which category the payment falls. The grounds for the payment should be supported by relevant documentation such as correspondence, a grievance, or a claim.

Taxation of payments on termination of employment is a complicated area of the law and we recommend employers take legal and accountancy advice when entering into an agreement with employees.

If you would like to discuss any aspect of this article further, please contact Sue King on 0113 244 6100.

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The information in this article is necessarily of a general nature. Specific advice should be sought for specific situations. If you have any queries or need any legal advice please feel free to contact Wrigleys Solicitors.