Taxation of Employee Contracts
As many HR professionals will know, the effect of taxation can often be unclear when negotiating termination payments for departing employees.
It is vital to get the tax treatment correct at the outset in order to avoid unnecessary costs to an employer.
Historically, the basic rule has been that "contractual" payments are taxable. However, it is not always clear when a payment is or is not "contractual". The tax treatment of a payment can sometimes be affected simply by the way a payment is described in a letter from the company to the employee.
If a payment is wrongly assumed to be tax free, then the Inland Revenue will often assume that the payment the employee has received is the net amount, and will seek to recover tax from the employer on a "grossed up" basis.
When does the exemption apply?
In some circumstances, the first £30,000 of a payment made on termination of employment may be paid free of income tax and may be exempt from national insurance contributions.
However, the exemption does not apply to all termination payments. It does not apply to payments which are "emoluments" and which are made under or in connection with the contract of employment. These are commonly described as "contractual" payments.
The issue was considered in the recent case of SCA Packaging Limited -v- The Commissioners for HMRC.
The case is useful for both lawyers and HR professionals as it illustrates the current approach of the Inland Revenue to taxation of employee termination payments and demonstrates just how complex these issues can be and that there may often be a very fine line between contractual and non-contractual payments.
It involved a number of employees and its facts were complicated.
The company, SCA Packaging, had made a number of employees redundant over a number of years. On each occasion the employees were given redundancy payments and payments in lieu of notice. None of the employees had payment in lieu of notice provisions in their written statements of terms and conditions of employment.
However, some employees were union members. Their employment was the subject of a Memorandum of Understanding entered into between the union and the company. The Memorandum regulated various matters, including termination of employment upon redundancy. It provided that upon termination for redundancy, the company would make redundancy payments and would make payment to the employee in respect of any unexpired period of notice. The Special Commissioner held that this term was incorporated into the employees' terms and conditions of employment and that it amounted to a contractual arrangement for payment on termination, rendering the termination payments to those employees fully taxable.
The other employees were office staff and were not members of the union. They did not know about the Memorandum. The Special Commissioner concluded that it did not apply to their employment and was not incorporated into their terms and conditions. The employer did not have a right to make a payment in lieu of notice and the termination payments made to those employees were therefore tax free up to £30,000.
Importantly, the Special Commissioner held that simply because the company had a policy of making termination payments and they were routinely made upon termination, did not in itself render them due to the employees and did not automatically make them taxable.
The Special Commissioner's decision also supports the view that an employee's prior agreement to a termination payment effectively operates as a variation of contract, so as to entitle the employee to a redundancy or termination payment as a contractual right. This is particularly so if the employment is not brought to an end immediately and the agreement is reached before the employment relationship is ended.
Conclusion
In practice, an employer will often seek a tax indemnity from the employee, so that the employee is responsible for any additional tax that may be due. However, for various reasons this is not always possible.
It is therefore important for an employer to be aware when termination payments may be subject to tax, to ensure that it gets the tax treatment right from the outset.
It is important to properly identify the source of the payment, and whether or not the payment is made "from the employment". This will determine the tax treatment of it.
Each case will turn on its own facts, but the following general principles will apply:
1. Contractual payments are fully taxable. This will normally include:
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payments which directly relate to an employee's notice period
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payments made where there is a contractual power for the employer to make a payment in lieu of notice (i.e. PILON clauses)
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termination payments made as a result of some other contractual arrangement, redundancy policy or side agreement
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termination payments agreed prior to the actual termination of employment. These are to be construed as variations of the employment contract, not compensation for its breach.
2. The £30,000 exemption will only apply to genuine non-contractual payments. This will normally include:
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ex-gratia payments, provided there is no prior arrangement for that payment
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payments which can clearly be attributed to damages to compensate a breach of contract by the employer.
Employers should be careful about how redundancy policies are worded and about how payments are communicated to employees.
Following the SCA Packaging case, it is possible that a letter to an employee proposing a termination payment could be construed as a variation of contract, with the effect that the termination payment is fully taxable.
For further information please contact: ALISON GOW OR ALASTAIR JOHNSTON