Termination payments: Get the details right, part 1

Sarah Bradford provides an overview of the payments that may be made on the termination of an employment contract and how they should be treated for tax and NI purposes.

25th Aug 2020
Director Writetax Ltd
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As the coronavirus job retention scheme starts to wind down, employers are faced with the difficult decision as to which employees they can bring back to work and whether they need to make any employees redundant.

Normal payments vs termination payments

When an employee is made redundant, there are various payments which may need to be made. Broadly, they can be split into normal payments and payments that the employee receives as a result of the termination (the termination award).

Normal payments are those made to the employee in the general course of their employment including wages, salary and accrued holiday pay. These are treated as earnings from the employment and liable to tax and NI when paid on the termination of employment as if they had been paid to the employee while the employment was ongoing.

Payments made specifically on the termination of employment make up the termination award. This may include pay in lieu of notice, compensation for loss of office, statutory redundancy pay, and non-cash benefits. Items included within the termination award may be taxed either as earnings or under the specific rules applying to termination payments in ITEPA 2003, Pt. 6, Ch. 3.

The £30,000 tax-free allowance only applies to payments that are taxed under the termination payment rules.

Taxation of the termination award

The first step is to find the relevant termination award by excluding any statutory redundancy pay to which the employee is entitled (or an equivalent amount paid under a contractual redundancy scheme).

Statutory redundancy pay, or equivalent contractual redundancy pay, is taxed as a termination payment under the rules in ITEPA 2003, Pt. 6, Ch. 3 and benefits from (and counts towards) the £30,000 tax-free threshold.

The relevant termination award is taxable as earnings up to the level of an amount known as the post-employment notice pay (PENP).

The calculation of the PENP can be quite complex and I will explore it in the second article in this series. Broadly the PENP is equal to the amount that the employee would have earned had they worked their notice period. Amounts taxed as earnings are included in gross pay for PAYE and class 1 NIC purposes.

Where the relevant termination award is more than the PENP, the excess is taxed as a termination payment and benefits from the £30,000 threshold to the extent that it has not already been used (for example, by statutory redundancy pay). Where amounts taxed under these rules exceed £30,000, the excess over £30,000 is taxable.

Statutory redundancy pay

An employee who has at least two years’ continuous employment when they are made redundant qualifies for statutory redundancy pay. This must be paid by the employer. Where the employer operates a contractual scheme, the amount paid must at least equal the statutory redundancy pay to which the employee is entitled.

The amount of statutory redundancy pay depends on the length of the employee’s service, their age when made redundant and the level of their wages. Employees are entitled to:

  • one and a half week’s pay for each full year that they were aged 41 and over;
  • one week’s pay for each full year that they were 22 and older but younger than 41;
  • half a week’s pay for each full year that they were under 22.

Service is capped at 20 years for the purpose of the calculation, and is counted back from the date that the employee was made redundant.

For 2020/21, pay is capped at £538 per week, meaning the maximum statutory redundancy payment for 2020/21 is £16,140 (20 years @ £538 per week x 1.5 weeks).

Where an employee is made redundant after being furloughed, time on furlough counts as part of the employee’s continuous service. Further, statutory redundancy pay should be worked out using the employee’s usual pay (generally the pay on which the furlough claim was based) rather than any lower amount that the employee received while furloughed.

National insurance

Payments made on the termination of employment which are treated as earnings are liable to employee and employer class 1 NIC and should be included in gross pay for national insurance purposes.

No national insurance liability arises on amounts covered by the £30,000 threshold. However, since 6 April 2020, where amounts taxed as termination payments exceed £30,000, the excess is liable to class 1A NIC. No employee contributions are due on amounts taxed under the termination payment rules.

Replies (9)

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By Paul Crowley
25th Aug 2020 20:19

Much appreciated

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By Munch
26th Aug 2020 09:53

It is important that terms of redundancy over and above statutory are dealt with in the employment contract. For larger payments over £30k, companies may well see a benefit in trying to pay these as pension constributions to avoid NIC.

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By pinksteven1981
26th Aug 2020 09:57

Do you have to show redundandy payment on the payslip or can it be done outside of payroll as one off payment not going through payroll?

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By AnonymousFD
26th Aug 2020 10:16

Can someone confirm that the taxation of termination rewards as outlined above does not come into play with settlement agreements?

I seem to remember the rules around that changing but was then surprised to see no reference to them above...

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By rod.ford
26th Aug 2020 13:54

Very useful information. Looking forward to Part 2.

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By raycad
26th Aug 2020 13:59

To Anonymous FD

Sarah's brief but excellent summary of the termination rules applies whether there is a settlement Agreement (SAg)or not. Typically an SAg will break down the payments between the three main elements, namely contractual, non-contractual and PENP. But even if not so broken down in an SAg, the tax treatment will in effect apply that split anyway. This is (or should be) the case both for PAYE/NI purposes and for the employee's SA return in due course.

There haven't been any recent rule changes overriding this but what you may, perhaps, be thinking of is when the PENP rules came in two or three years ago. Prior to that, to establish the tax position, one had to to look at the employment contract to ascertain whether a payment was contractual or not. Broadly speaking, a clause which gave the employer the absolute discretion as to whether to give notice or make a payment in lieu thereof (a PILON) was held by the Courts to be a contractual entitlement and hence taxable in full. Where the contract was silent on this the PILON was akin to a breach of contract payment and so qualified for the £30k tax-free slice. Since the introduction of the PENP rules, however, this distinction has been pretty well rendered redundant (pun intended!)

It was a great pity (though no great surprise) that, during the consultation process and in the subsequent legislation, the opportunity was not taken to increase the £30k limit, which has been around for donkeys years now. Even before it was increased to £30k, the limit was £25k (and I believe that this went back to the 1970s, at least) when the SRP element would have typically used up no more than about 10% of the tax exemption. As Sarah's article says, the maximum SRP nowadays is well over £16k and so uses up over the half of the £30k. Another instance of, I'm sure, wholly intentional fiscal drag.

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By ds
07th Sep 2020 16:09

For one man limited companies, sometimes known as PSC, who are facing the end of this arrangement from April 2021 postponed from this year because of Covid, can this £30,000 tax free redundancy payment be claimed when closing down the Limited company ?

I have discussed this previously with two accountants who looked into it and concluded it could not be utilised although I remain unconvinced because if the director is also an employee of the company, is registered under PAYE, has an employment contract and returns RTI data each month, then why should it not apply to them too?

I am interested to hear arguments for and against.
Thanks

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Replying to ds:
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By raycad
07th Sep 2020 17:18

(Replying to DS)

A one-man company with an employment contract with his own PSC? Are you quite sure? Never seen one of those in over 40 years working in tax! Might be a contract with the Agency or end client perhaps but between him and his own company?? Surely not.

When a director decides to close down a company he will normally be doing that for commercial reasons, maybe because the work has dried up, he has decided to retire, work offshore or maybe take up an employment instead. Although, by dint of being a director, this brings his directorship (and hence his "employment") to an end that doesn't, of itself, make it sufficient to justify effectively giving himself a termination award. On any objective basis, that's simply self-enrichment and an inevitable consequence of his own commercial decision to wind up the company.

I know that there have been one or two voices on here over the years who have expressed the opposite view but, personally, as an employment taxes specialist, I'm on the side of the two accountants you've spoken to. Certainly HMRC will be!

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By ds
07th Sep 2020 17:08

Hi raycad, Thanks for your quick reply.

An employment contract can simply be a single page with words to the effect you are hereby employed by XYZ Limited on a salary to be determined each year. Legally I understand a contract can even be made verbally.

The reason for closing down the company is brought on by changes in legislation or tax practice which makes the limited company model inoperable. The government have decided to disallow this method of working and would prefer contractors to be employed by big corporates directly and pay their taxes like everyone else, without regard for the differences in employed and self-employed conditions. I think they are making a big mistake but they have made many recently so why stop now?

It seems to be a grey area and the two accountants I think were playing on the safe side to say it wouldn't probably be allowed but has it ever been tested ? The director is a legal person managing the overall direction and legal-tax compliance of the company and could in effect be paid zero pounds for his services. The same person working for the company, and actually doing the real work which brings home the bacon, is paid a salary and to all intents and purposes is an employee who is now facing redundancy due to circumstances beyond the control of the company.

I expect in the next few months this director/employee redundancy problem will cease to be academic and become a reality.

Thanks.

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