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TaxZone Newthwire 53: Termination of Employment

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1st Jan 2005
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TaxZone Newthwire
Issue 53 - 7 June 2004 - Termination of Employment
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Editorial note
The tax consequences following termination of employment are complex, to say the least. The leaving arrangements may simply involve a resignation and the working out of notice, which are unlikely to have serious tax consequences. However, such a scenario is increasingly unlikely in today's society. The tax adviser is much more likely to be faced with issues arising from payments in lieu of notice, redundancy, compensation for loss of office or an ex-gratia payment.

There is an extraordinary amount of legal, tax and other
material available on this subject, but in this wire I will
attempt to guide subscribers in the right direction, should they be faced with a practical problem in this area.

Regards,
John T Newth
mailto:[email protected]

Disclaimer
==========
No responsibility for loss occasioned to any person acting or
refraining from action as a result of any information in this
wire is accepted by the author or AccountingWEB. In all cases,
appropriate professional advice should be sought before making
a decision.

Statutory law
=============

Section 309, ITEPA 2003 confirms that a statutory redundancy
payment is exempt from tax. However, such a payment is taken
into account for the purposes of the 30,000-pound exemption
(see below).

The sections that used to deal with termination of employment in
the Taxes Act 1988 were section 148 and 188. These have now been
repealed, and the main legislation is considered in sections
401-406, ITEPA 2003. Section 403 deals with the 30,000-pound
exemption available in certain circumstances.

Payments in lieu of notice form the subject of Revenue
Interpretation RI 249, updated in February 2003. This subject
will be discussed later in the wire, but even the Revenue admits
that the tax situation is not clear-cut, and is largely based on
(sometimes conflicting) case determinations.

Tax cases
=========
There are numerous tax cases on the subject of termination of
employment, and I do not intend to review them all in detail.
However I will discuss some of the more important cases.
Subscribers who wish to research cases generally should refer to
Tolley's Tax Cases 2003 at 14.1-14.12, 61.56-61.58 and 65.131-
65.152.

Redundancy
==========

Mimtec Ltd v CIR SpC 277
------------------------
A manufacturing company made a large number of employees
redundant and, following negotiations with the relevant union,
made payments of 2,500 pounds to each employee in recognition
of any rights under the Trade Union and Labour Relations
(Consolidation) Act 1992. The Revenue issued regulation 49
determinations, but these were successfully appealed to the
Special Commissioner. The company's contention that each payment
was covered by the 30,000-pound exemption was accepted, and the
Commissioner held that each payment was statutory and did not
arise from the employer and employee relationship.

Payments in lieu of notice
==========================

EMI Group Electronics Ltd v Coldicott [1999] STC 803
----------------------------------------------------
In a case that reached the Court of Appeal, a company made
payments in lieu of notice to two senior employees who had been
made redundant. Tax was not deducted and the Inland Revenue
issued regulation 49 determinations. The company appealed,
contending that the payments made were not emoluments. However
this contention was rejected by the Commissioners and the
courts, which held that the payments were made in accordance
with the relevant contract of employment. Accordingly the
payments were emoluments rather than additional redundancy
payments. The Revenue conceded that payments in lieu of notice
made to junior employees were not taxable emoluments, since the
employees had no contractual right to them.

Ex-Gratia Payments
==================

Mairs v Haughey [1993] STC 569
------------------------------
An employee of a government owned, loss-making company waived his
rights under a non-statutory redundancy scheme and accepted new
employment in a new 'buy out' company. He received an ex-gratia
payment of 5,806 pounds, 1,300 pounds of which was paid by the
new company and 4,506 pounds by the Department of Economic
Development. In a case that reached the House of Lords, it was
held that the 1,300 pounds was taxable as an inducement to enter
into the new employment. However the amount of 4,506 pounds was
not taxable, since it was neither an emolument nor a benefit.
This amount was compensation for loss of rights under a non-
statutory redundancy scheme.

Compensation for Loss of Office
===============================

Richardson v Delaney [2001] STC 1328
------------------------------------
An employee was summarily dismissed, and requested not to attend
the office. Under his contract he was entitled to 18 months
notice of termination or to continue to pay his salary in lieu of
notice. Following negotiations the employee accepted an amount of
75,000 pounds. The Revenue assessed the whole amount under what
was
section 19, Taxes Act 1988 as Schedule E emoluments. The company
contended that the first 30,000 pounds was exempt, but the High
Court judge held that the whole amount arose from the employee's
contract of employment and was therefore chargeable to tax.

The Gourley Principle
=====================

British Transport Commission v Gourley 1955 34 ATC 305
------------------------------------------------------
In a case which did not concern termination of employment a
civil engineer was awarded damages against the British Transport
Commission. The gross amount of damages was 37,720 pounds, but
was reduced to 6,695 pounds after calculating hypothetical
income tax and surtax. The House of Lords held that the lesser
amount should be included in the award. This principle was
followed in the following cases regarding termination of
employment:
# Stewart v Glentaggart Ltd 1963 42 ATC 318
# Parsons v BNM Laboratories Ltd 1963 42 ATC 200
# Bold v Brough Nicholson & Hall Ltd [1963] 3 All ER 849
# Lyndale Fashion Manufacturers v Rich [1973] STC 32

Non-taxable compensation
========================

Dunnachie v Kingston upon Hull City Council
-------------------------------------------
In an employment law case that went to the Court of Appeal, it
was accepted that Mr Dunnachie had been constructively and
unfairly dismissed as a result of a prolonged campaign of
harassment by a colleague, not dealt with by his employer.
Following the recent House of Lords case of Johnson v Unisys,
the Court of Appeal took into account the remarks of Lord
Hoffman, and awarded 10,000 pounds for non-pecuniary loss due to
distress, humiliation etc. It should be noted that that part of
the award is tax-free.

Reinstated Employee
===================

Wilson v Clayton
----------------
In a recent case a former employee of a local authority was
awarded 5,060 pounds following proceedings at an employment
tribunal. The local authority had dismissed employees and then
re-employed them on terms that excluded a previously granted car
allowance. The Tribunal ordered the authority to reinstate the
employees with restoration of the car allowance, and to pay each
of them the amount of lost remuneration from the date of
termination to the date of reinstatement. The High Court held
that the 5,060 pounds awarded to Mr Clayton in this connection
came within what was section 148, Taxes Act 1988, and was not
taxable.

Other Published Material
========================
Extensive commentary regarding termination of employment, in all
its varieties, is included in the Inland Revenue Manuals. The
Employment Income Manual includes commentary at EIM 12800-EIM
13995, and this is duplicated in the Schedule E Manual at SE
12800-SE 14000.

The main source of reference from the professional publishers, of
which I am aware, is the book Tolley's 'Tax on Termination of
Employment' by Donald Pearce-Crump. Chapters on the subject also
appear in 'Tolley's Tax Planning' and 'Tolley's Taxation of
Employment'.

Basic principles
================
It is difficult to state clear principles on a subject that
is so complicated, and affected by so much case law, and the
statements below are generalisations. The facts in each case
are different, and have to be considered in the light of
current case and statutory law. This is an area where the
practitioner will almost certainly need specialist help in
one form or another. However, a simplistic view of legislation
and practice is:

# Statutory redundancy pay is exempt from tax, but forms part of
the 30,000 pounds exempted under section 403, ITEPA 2003, where
additional amounts are paid. The exemption may also extend to
non-statutory redundancy pay.

# Compensation for loss of office and payments in lieu of notice
are taxable as earnings if the payments arise from a contractual
right.

# Ex-gratia payments may or may not be taxable, depending on the
facts of the case. If they arise on death or retirement, the
view of Pension Schemes Office is that they are retirement
benefit schemes and are remuneration.

# Non-contractual compensation from loss of office and non-
contractual payments in lieu of notice may not be taxable as
emoluments, depending on the facts of the case. An example of
this is where compensation is agreed following breach of
contract by the employer. It is unlikely that provision for
payment in lieu of notice would not be included in a modern
employment contract. Where such payments are not taxable as
emoluments, they will be exempt up to 30,000 pounds in
accordance with section 403.

# Payments agreed not to be assessable as remuneration are tax-
free to the extent of 30,000 pounds in accordance with section
403, ITEPA 2003.

The 30,000 pounds exemption
---------------------------
The application of the 30,000 pounds exemption is best
illustrated by a number of examples.

# Example 1 - Payment in excess of 30,000 pounds
Hubert receives 50,000 pounds from his company's non-statutory
redundancy scheme on leaving the company early in 2004. It is
agreed that 25,000 pounds will be paid on 1 April 2004 and
25,000 pounds on 1 July 2004.

The amount of 25,000 pounds paid in 2003/2004 is exempt.
However, only a total of 30,000 pounds is exempt, so that only
5,000 pounds of the 25,000 pounds paid on 1 July 2004 in
2004/2005 is exempt.

# Example 2 - Two successive redundancies
Edwin is made redundant on 28 February 2004 and receives a
payment of 30,000 pounds. This is exempt by virtue of section
403, ITEPA 2003. He obtains new employment with a company not
associated with his previous employer. Unfortunately that does
not work out, and he is made redundant again on 31 December 2004,
being paid 20,000 pounds. This payment is also exempt under
section 403, and he has had the benefit of two exemptions. The
payment from the second employer would also have been exempt up
to the exemption limit of 30,000 pounds.

# Example 3 - Made redundant twice by same employer
Fred is made redundant on 31 March 2004 and is paid 20,000
pounds. He manages to obtain a job with the same company on 1
June 2004, but is made redundant from that post on 31 January
2005, being paid a further 15,000 pounds.

Only one exemption is available because Fred's employer in both
instances is the same person. Accordingly the whole of the first
payment of 20,000 pounds will be exempt, but only 10,000 pounds
of the second payment. This should be contrasted with Example 2
where different employers are concerned.

# Example 4 - Associated employers
Rupert works for Widget Ltd, which owns all the shares in
NutsandBolts Ltd. He is made redundant from Widget Ltd on 31 May
2004, and receives a payment of 25,000 pounds within section
403. Six months later he joins NutsandBolts Ltd, but leaves
that company on 31 January 2005. Following a claim for wrongful
dismissal he receives a payment of 10,000 pounds.

NutsandBolts Ltd is deemed to be associated with Widget Ltd, so
only one 30,000 pounds exemption is available to Rupert.
Accordingly the 25,000 pounds received from Widget Ltd is tax-
free, but only 5,000 pounds of the payment from NutsandBolts Ltd
is tax-free.

# Example 5 - Instalment payments in same tax year
Arthur receives a termination package of 45,000 pounds, with
22,500 pounds payable on 30 April 2004 and 22,500 pounds payable
on 31 October 2004. The April instalment is tax-free, but only
7,500 pounds of the October instalment. This means that 15,000
pounds will be charged to tax as an emolument in 2004/2005.

# Example 6 - Instalment payments in different tax years
Cuthbert receives a termination package of 60,000 pounds, with
20,000 pounds payable on 1 January 2004, and similar amounts on
1 January 2005 and 1 January 2006. Only one 30,000 pounds
exemption is available. Therefore the payment on 1 January 2004
will be tax-free. 10,000 pounds of the payment on 1 January 2005
will be exempt, with the remaining 10,000 pounds taxable. The
whole of the 20,000 pounds payable on 1 January 2006 will be
subject to tax.

Any Answers
===========
Not surprisingly the subject of termination of employment has
invited many queries and comments on the Any Answers site. The
following is a selection:

Redundancy payment
------------------
Gavin Rickwood was made redundant in April 2000, and received a
payment of 28k, which happened to be six months salary. His job
contract stated that notice periods on either side were six
months. His former employer had paid the amount gross, assuming
that it came within the 30,000 pounds exemption. However, the
initial view of the Revenue was that significant amount of tax
may be payable.

There were several replies to this query, some urging that Gavin
should obtain professional advice as he is not an accountant.
Joanne Nock suggested that a copy of the employment contract
should be sent to the Revenue. Marc Selby confirmed that even
where the payment under the redundancy was a contractual
entitlement, then the 30,000 pounds exemption should still apply.
Jeremy Barker distinguished between a statutory redundancy
payment and a contractual payment. Roger Rabbit put forward a
dissenting view, quoting Delaney v Richardson.

Lesley Fidler suggested that the 28,000 pounds could be enhanced
redundancy payment, and therefore exempt. Gavin Rickwood came
back to say that his redundancy was a unilateral decision by his
employer, and the dismissal letter made it clear that it was on
the grounds of redundancy.

This query illustrates the complexity of law and practice, and
the differing views of tax professionals. I would have thought
that, subject to competent advice and submission of the
correspondence and employment contract to the Revenue, that
Gavin ought to be able to obtain assurance that the 28,000
pounds was not taxable(ie at least within the 30,000-pound exemption).
https://www.accountingweb.co.uk/item/80923/786/784/785

Redundancy pay - taxable?
-------------------------
Paul disclosed that he would be made redundant following a
takeover by another company, in his query of 17 May 2002. He
would probably be joining the new company. The old employer
states that tax and NIC will be applied to the redundancy
payment. Was this correct?

Marc Selby emphasised the general principle that a genuine
redundancy payment is free from tax and NIC. However the fact
that Paul is likely to work for the new company casts a doubt on
whether this was a genuine redundancy. Professional advice was
desirable.

Phil Rees confirmed that if Paul's role with the new company was
the same as before (or enhanced) he was unlikely to succeed. The
advice to obtain advice from an employment law solicitor was
good. G Smith referred to TUPE. The old employer is probably
going to issue a compromise agreement that must be witnessed by
an independent legal adviser. It may be best to wait for this to
happen, as some legal costs might be saved.
https://www.accountingweb.co.uk/item/81130/786/784/785

Redundancy tax
--------------
Greg Coomber propounded the situation where an individual was due
45,000 pounds redundancy pay, in his query of 4 November 2002.
The person involved had been told that the tax deducted from the
15,000 pounds in excess of the 30,000 pounds exempt amount could
be reclaimed. Phil Rees confirmed that this was 'gin and tonic'
talk and not correct. The 15,000 pounds was taxable, and must be
entered on the self-assessment tax return.
https://www.accountingweb.co.uk/item/95548/786/784/785

Redundancy v Loss of Office
---------------------------
Emma put forward the case of a senior management client who
would be leaving her employment shortly, in her query of 26
March 2003. he company would pay 30,000 pounds compensation for
loss of office, straddling two tax periods. Emma needed
confirmation that the payment would be tax-free under section
148 (now section 403, ITEPA 203).

Paul Soper outlined the principles at stake in this case. If the
30,000 pounds settlement had been negotiated contractually
before employment ceased, then it would be taxable as earnings.
The sum payable sounded suspiciously equivalent to the exemption
limit, but does come within that limit if it was genuine
redundancy.

Payment of an ex-gratia amount might be safer. The Revenue
accepts that an agreement not to sue for unfair or wrong
dismissal is not an undertaking within section 313, Taxes Act
1988 (payment for restrictive covenants - now repealed).
https://www.accountingweb.co.uk/item/106423/786/784/785

Redundancy - likely pitfalls?
----------------------------
KMF had heard that the 30,000 pounds exemption limit was
changing in the future. Was this true? His friend had also
received a suggestion that the 30,000 pounds exempt payment
should be invested directly into his pension. In addition his
employers have stated that he will be able to come back to them
as a self-employed contractor for specific projects. Does this
ring any alarm bells? Query dated 18 November 2003.

Dave Grimley highlighted the two main problem areas:
# The Revenue may challenge the tax-free status of the
termination payment.
# There may be an employment status challenge on re-engagement.

There were no plans to increase the 30,000 pounds exemption
limit. If the Revenue were able to argue casual employment
status in the future, it could prejudice the character of the
redundancy payment already made, which could be seen as a
payment made to alter the terms and conditions of the
employment, and therefore taxable. Ray Levy considered that the
potential pitfalls were not serious, as this type of transaction
was commonly undertaken.

Paul Gittins commentated as one who had been investigated post
redundancy. Remember that the Revenue is unlikely to agree the
status of the transaction in advance. Once you have left
employment you are on your own. All documentation, even if going
back 20 years or more should be retained, including notes of
meetings, letters and, most importantly, the contract. The
Revenue finally conceded Paul's case, but not until after months
of negotiation.

Susanna Russell Smith could not see why the 30,000 pounds should
be invested in the pension fund. It was wise, however, to invest
any amount in excess of that figure into the fund, as this was
tax- efficient.

Finally Dave Grimley suggested that a pre-transaction ruling
from the Revenue under Statement of Practice SP 1/94 could be
of assistance, if this was a non-statutory redundancy situation.
https://www.accountingweb.co.uk/item/119975/786/784/785

Redundancy and one-man limited company
--------------------------------------
"tab" asked whether a payment of up to 30k could be made
tax-free by a one-man limited company, being tax deductible
by the company and tax-free in the hands of the owner/director,
on 7 November 2003.

Paul Soper observed that redundancy occurs when a company needs
fewer employees, and this did not appear to be the case here. To
come within the exemption it would be necessary to show that the
payment was ex-gratia, and it was difficult to see how this
could be done. Redundancy is calculated on length of service as
well, and it is most unlikely that the calculation could produce
30,000 pounds.

A better solution might be to declare a dividend or extraction
of cash by liquidation if 75% taper relief was available.
https://www.accountingweb.co.uk/item/119683/786/784/785

Compensation for loss of office from own company?
-------------------------------------------------
A broadly similar query with different facts was posed by G
Phillips on 20 May 2002. One director/shareholder of a two-man
company had had to retire due to illness. He had been
responsible for the income of the business. In the
circumstances, could he be paid 30,000 pounds tax-free
compensation for loss of office, out of 40,000 pounds available
profits?

Roger Rabbit made the valid point that a redundancy only occurs
if the position disappears, not if it is the person who
disappears. The facts of the case could be placed before the
Revenue. Montrose questioned whether the amount would be
deductible for CT purposes. If trade has already ceased, is the
payment 'wholly and exclusively' for the purposes of the trade.
https://www.accountingweb.co.uk/item/81245/786/784/785

Compensation for loss of office
-------------------------------
Kevin Salter queried the position where a director is being
required to 'resign' now, in his query of 21 October 1999. Could
a tax-free payment of up to 30,000 pounds be paid to him in
twelve months' time, in a different accounting period?

Garth Murphy warned that if shares held for less than 5 years
are being bought from the director, Revenue approval should be
obtained. I would suggest that the main issue is that of the
director's contract with the company. If the payment can be seen
to be contractual, then it will be taxed as earnings. If not,
there is every possibility that up to 30,000 pounds could be
paid tax-free.
https://www.accountingweb.co.uk/item/7654/786/784/785

Compensation for early retirement
---------------------------------
Another query posed by Kevin Salter on 6 February 2000 concerned
an employee due to retire at 65 being offered a redundancy
package at 63. He would be offered 20,000 pounds compensation
plus a cash sum from the pension fund. Would these transactions
be open to challenge?

David Heaton considered that if the inspector could be convinced
that there was a genuine redundancy within the definition of the
Employment Rights Act, then the payment of 20,000 pounds should
be tax and NIC free. Tristan Maynard set out the basic
provisions of what was then sections 148 and 188, Taxes Act
1988. My view is that these transactions would probably be
challenged by the Revenue, and that specialist advice should
be obtained.
https://www.accountingweb.co.uk/item/12413/786/784/785

Payment in lieu of notice - when taxable
----------------------------------------
Ian Riley queried the position of a friend who was negotiating a
leaving package in late 2001, in his query of 28 October 2001.
The period of notice would include a period that ran into the
2002/2003 tax year. It would be much more tax beneficial for the
PILON to be assessed and taxed in 2002/2003 rather than
2001/2002, as the lady concerned was a 40% taxpayer. Could a
request to the revenue be made for at least part of the proposed
payment to be taxed in 2002/2003?

A number of subscribers drew attention to the fact that a PILON
is not taxable provided it was not contractual and less than
30,000 pounds. Ian confirmed that compensation would already
exceed 30,000 pounds, so that the query only concerned the tax
year in which the PILON would be taxed. Neil Eglintine suggested
that the payment should not be made in a lump sum, but paid on
the normal salary due dates in 2001/2002 and 2002/2003. This
would at least deal with part of the problem.
https://www.accountingweb.co.uk/item/61815/786/784/785

Ex-gratia payment
-----------------
On 15 April 2004 "ans" mentioned the case of a director who was
retiring in five years time. The company had agreed to pay him
an ex-gratia payment of 12,000 pounds. Can this be paid
commencing now at the rate of 2,400 pounds per annum?

'Montrose' confirmed that the golden handshake legislation,
now in part 6, Chapter 3, ITEPA 2003, only applies where the
payments are not chargeable to tax apart from that legislation.
Any prior agreement to make the payment will mean that it is
taxable in the ordinary way as emoluments.

Even without prior agreement, the Revenue are of the view that a
golden handshake or ex-gratia payment at retirement is taxable
as a 'relevant benefit' under a retirement benefit scheme and so
taxable (see Revenue Statement of Practice SP13/91). There may
be a possibility of making a payment in the absence of any
entitlement to a lump sum under a pension scheme.
https://www.accountingweb.co.uk/item/125373/786/784/785

Ask a question
==============
Readers with a current case should post their query in Any
Answers.

JOHN T NEWTH
https://www.accountingweb.co.uk/premium_content/newthwire

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