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Tolley's Practical Tax by Mike Evans

Mike Evans, Director of Employment Taxes at PKF (UK) LLP, looks at the income tax and Class 1 NICs treatment of compensation payments made and benefits in kind provided on and after the termination of employment.HM Revenue & Customs (HMRC) has over a number of years identified termination payments as a ‘top ten’ target for employer compliance settlements. It is actively targeting the income tax and Class 1 NIC treatment of termination payments when its Employer Compliance teams carry out inspections. Its specialist Risk Intelligence and Analysis Teams (RIAT) will single out cases where payments in excess of £30,000 have been made and need to be looked at, either as part of a full review or as an aspect enquiry (looking at the one specific risk area).

HMRC officers from the Large Business Office (LBO), Employer Compliance and Area Compliance Offices, are identifying employers that have been making large numbers and/or amounts of redundancy payments when carrying out pre-inspection ‘risk and research’ exercises. The LBO preinspection questionnaire, which can be downloaded from the HMRC website, asks some searching questions covering ex-gratia, redundancy and other lump sum payments, as well as retirement awards and restrictive covenant payments.

If there is any indication of such payments having been made, from the completed questionnaire, or from other information available to the HMRC, the officers are likely to ask for a lot of information – perhaps covering many years. The writer recently advised on an enquiry that was picked up from local newspaper reports of redundancies at an out of town trading estate. The area office moved from one employer to another on that estate, picking them off and apparently enjoying ‘rich pickings.’ After lengthy correspondence and a couple of face-to-face meetings, the enquiry was settled without any payment in relation to the termination payments that had been made in the six years under review. A number of misunderstandings had to be dealt with and a lot of research done to disprove some wrong assumptions.

The failure to operate PAYE and deduct Class 1 NIC could leave the employer with a bill for the income tax and employees (Primary) and employers (Secondary) Class 1 NICs that should have been deducted. Interest and penalties will be added to rub salt in the wound. This can amount to a very significant sum: even small payments can trigger large liabilities if a number of them have been made.

The tax lost on the first £30,000 incorrectly treated as exempt might only be £12,000 (at 40%), but if no Class 1 NIC was deducted from a £300,000 contractual payment, the bill rises by another £41,400 (£300,000 x 12.8% Secondary + 1% Primary contributions).

At a recent employer compliance inspection of a large employer in the South of England the officer requested the following information:

1. a list of all termination payments made in the accounting period ended 30 April 1999;

2. a copy of the contract of employment for each of the former employees;

3. a copy of the notification letter and of any correspondence related to the termination of employment and award of compensation;

4. a copy of any staff handbook or redundancy policy document;

5. details of any continuing benefits provided after the date of leaving and an explanation of how these have been reported;

6. a copy of the calculation of payments comprised in the termination package.

The officer heading the inspection said that when this information is provided, it is to be referred to a termination payments specialist for advice on the income tax and Class 1 NIC treatment.

It is important to remember at the outset that the £30,000 exemption does not apply to payments ‘otherwise chargeable to tax’ and that there is no £30,000 exemption limit for Primary or Secondary Class 1 NICs. If the termination payment is non-contractual it should be excluded from the definition of earnings and Class 1 NICs will not be due, whatever the amount. If the termination payment is a contractual payment, it will come within the definition of earnings and Class 1 NICs will be due on the whole amount.

Types of Payments

The main types of termination payment to be considered when a director or an employee leaves his or her office or employment, voluntarily or without choice, are as follows:

1. compensation for loss of office or employment;

2. statutory and non-statutory redundancy payments;

3. payments in lieu of notice;

4. ex-gratia payments;

5. restrictive covenant payments; and

6. payments in commutation of pension rights.

Most of the problems that occur in relation to these payments arise from the assumption that the first £30,000 is always exempt from income tax and Class 1 NICs. If the assumption is correct, the whole of the payment, without any monetary limit, should be regarded as ‘excluded from earnings’ for Class 1 NIC purposes. If Class 1 NIC has been deducted from the excess over £30,000 – which is wrong – a repayment should be obtained.

Employers are putting themselves at risk if they assume that all such payments are exempt up to
£30,000, without first seeking legal and tax advice. The failure to operate PAYE and deduct Class 1 NIC will normally result in recovery being made from the employer. The settlement could include the unpaid income tax, Class 1 NIC, interest and penalties.

Contractual Payments

If the payment is made under a contract that promises to pay compensation, or if it is in any way a reward for services past, present or future, the whole amount will be within ITEPA 2003 s 62 and will be liable to income tax and Class 1 NIC. As noted above, HMRC will look for evidence of this in any contract of employment, engagement letter, staff handbook or company correspondence or even minutes of a board meeting. HMRC guidance also refers to a side letter, redundancy or union agreement.

Any payment made voluntarily by an employer to compensate an employee or director for his loss of employment or office will not be earnings for contribution purposes, irrespective of the amount paid by way of compensation. However, a payment made under the express or implied terms of the Contract of Employment would be regarded as earnings and liable to Class 1 NICs on the full amount.

‘Garden Leave’

It is often the case that organisations that see part of their business going out of the door with a key employee who leaves, send the employee home on ‘garden leave’. Payments made to an employee during garden leave are not compensation payments that are excluded from the definition of earnings for Class 1 NIC purposes and do not fall within section 401. Class 1 NIC, along with income tax, should be deducted in the normal way.

Payments in lieu of notice (PILON)

It is the writer’s view that HMRC used to accept that a PILON was not a contractual payment where the contract provided for a period of notice, which was not subsequently given, providing that there was no provision in the contract for a payment in lieu of notice to be made.

HMRC’s current view on PILONs appears to be that they are either:

• contractual;

• non-contractual but emoluments; or

• damages.

In recent years, following HMRC’s success in EMI v Coldicott and Delaney v Richardson, it had been accepted that a discretionary provision in a contract of employment, giving the employer the right to make a PILON constituted a contractual entitlement (earnings for Class 1 NIC and liable to income tax under section 62).

The Court of Appeal appeared to have overturned that view in January 2001 in an employment law decision, Rowley v Cerberus Software Ltd, 2001 All ER (D) 80 (Jan). Lord Justice Ward said that ‘this is an interesting appeal on a troublesome little point of employment law’. The Court considered a clause in the contract providing that the employer ‘may’ make a PILON. It held that the word ‘may’ did not mean that the employer had a contractual requirement to make a PILON, but instead had breached the contract and was liable to pay damages for that breach. This allowed the employer to make a reduced payment of the mitigated loss suffered by Mr Rowley.

HMRC reacted to the decision by issuing new guidelines on the tax treatment of PILONs in Tax Bulletin 63. It ‘now accepts that it is unlikely that an implied contractual term in relation to PILONs can exist’. However, HMRC states that ‘where a PILON is paid as an automatic response to a termination, it may be within the scope of section 62 and liable for NICs’. The example given is one where all employees receive a PILON every time for unworked notice periods.

The writer has never come across an employer that ‘always’ makes PILONs, because there are usually directors or employees that want to, or are required to, work their notice. These people might be described as the ‘good leavers’. It is also commonplace to find that employees have been given notice, worked part or all of the notice period and then still be paid an amount of compensation that includes a payment described as a payment in lieu of notice. It is clear that such a payment is not a PILON and would be more properly described as enhanced redundancy or compensation.

Restrictive Covenant Payments

Where a payment is made in consequence of the employee agreeing to some form of restriction on his business activities after leaving the employment, the payment or any ‘valuable consideration’ given will be liable to income tax and Class 1 NIC.

HMRC could challenge cases where no payment is made for the restrictive covenants, or where a derisory amount, perhaps one penny, is included. It is something that should be considered and where it is appropriate more than a nominal amount should be included to cover any restrictive covenants in the contract or compromise agreement. The restrictive covenant payment should be made net of income tax and Class 1 NIC.

Unapproved Retirement Scheme Payments

Statement of Practice SP13/91 notified a change of HMRC practice in relation to ex-gratia payments made on termination of an office or employment on retirement or death. These payments are outside of the income tax exemption provisions and should not be regarded as earnings for Class 1 NIC purposes. Payments on death may be chargeable under ITEPA 2003 s 393 rather than ITEPA 2003 s 401, if a non-approved retirements benefits scheme exists.

If the payment is to be made to an employee who is not in a company pension scheme the employer may apply to the HMRC Pension Schemes Office for approval to paying the ex-gratia award gross. Formal approval is not necessary for certain small payments, where the payment does not exceed one-twelfth of the pensions ‘earnings cap,’ providing the other conditions are satisfied.

Pension provision will often form part of the planning considerations when an employment is being terminated, even where there may be some years to go before retirement. If someone is negotiating a termination package and the person leaving is at or close to retirement age, where there is a threat of SP13/91 being invoked, an employer contribution into an approved pension scheme may be a better way forward. Such a payment cannot be substituted for moneys due under an existing contractual entitlement, but it can be an effective way of saving Class 1 NIC and income tax.

Compensation Payments

Genuine compensation payments, that are not contractual, nor payments for services past, present or future will potentially be exempt from income tax up to £30,000 and, currently still without limit, are excluded from the definition of earnings for Class 1 NIC purposes. ITEPA 2003 s 401 charges ‘payments and benefits not otherwise chargeable to tax, which are received in connection with:

(a) the termination of a person’s employment, or

(b) any change in the duties of, or emoluments from a person’s employment, if and to the extent that their amount exceeds £30,000’.

The second leg of this exemption should not be overlooked, especially where a director or employee accepts a reduction in duties and salary, perhaps as part of a phased retirement.

The £30,000 exemption limit applies to all payments and benefits, which are charged by this section. If an employee were to receive a cash lump sum of £25,000 and the continued provision of a benefits package of say £2,000 per annum for three years, the exemption will be applied to the cash lump sum and £2,000 benefit in year 1, to £2,000 benefit in year 2 and the balance of £1,000 in year three.

There is a tax charge only in respect of the benefits in kind that are actually enjoyed and both the payments and any benefits are taxable for the year in which they are received or enjoyed, rather than on the date of termination of employment.

Redundancy Payments

Redundancy payments are made when an employment is terminated by reason of redundancy, not because an employment is terminated for some other reason. The best definition of redundancy can be taken from the Employment Rights Act 1996:

For an employee to be dismissed by reason of redundancy the dismissal has to be:
‘attributable wholly or mainly to:

• the fact that his employer has ceased, or intends to cease, to carry on business for the purposes of which the employee was employed by him, or has ceased, or intended to cease, to carry on that business in the place where the employee was so employed, or

• the fact that the requirements of that business for the employee to carry out work of a particular kind, or for the employee to carry out work of a particular kind in the place where he was so employed, have ceased or diminished or are expected to cease or diminish.’

Regulation 25 and paragraph 6 of Part X of Schedule 3 to the Social Security (Contributions) Regulations 2001 provide that ‘For the avoidance of doubt, in calculating the earnings paid to or for the benefit of an earner in respect of an employed earner’s employment, any payment by way of a redundancy payment shall be disregarded’.

The use of the term ‘For the avoidance of doubt’ means that in the doubtful, but not impossible, event of a redundancy payment actually constituting earnings, it is still to be excluded from the calculation of earnings for NICs purposes. Statutory redundancy payments are exempt from tax as employment income, but remain taxable under section 401 as termination payments (subject to the £30,000 exemption).

Non-statutory redundancy payments are also normally treated as within section 401, qualifying for exemption up to £30,000 for all non-contractual payments.

Mairs v Haughey

Guidance on the nature of redundancy payments can be found in the decision of the House of Lords in the Mairs (Inspector of Taxes) v Haughey (1993) case. See SE13750.

In that decision Lord Woolf refers to a redundancy payment as having a real element of compensating or relieving an employee for the consequences of their not being able to continue to earn a living in their former employment. He also observes that such payments, instead of being a payment from an employment, are payments made to compensate the employee for not being able to receive the emoluments from their employment.

Miscellaneous

Foreign Service Exemption

A payment or benefit is excepted from charge under ITEPA 2003 s 413 if it relates to an office or employment that includes certain periods of foreign service. The legislation provides for the exemption of the total payment for Foreign Service if that service amounted to at least 75% of the total service or the whole of the last 10 years. Alternatively where the length of service exceeded 20 years and the foreign element represented at least 50% of the total and there were at least 10 years of Foreign Service within the last 20 years, the full exemption applies. Where the full exemption does not apply, a proportionate reduction may be claimed, calculated on a pro-rata basis. A taxpayer can claim the foreign service deduction by notice in writing to the Inspector at any time up to 5 years after 31 January following the end of the relevant year of assessment.

Outplacement Counselling

Payments for outplacement counselling services paid for by the employer are exempt under ITEPA 2003 s 310, and exempt from tax, where generally available to all employees or to a particular class of them. The employee must have been employed for two years and the purpose must be to enable the employee to adjust to unemployment or to gain new employment or self-employment.

Payment for injury or disability

A termination (or change) payment is excepted from tax under ITEPA 2003 s 401 if it is paid on account of a physical injury to the holder of an office or employment, or the disability of such a person, if the injury or disability causes the termination (or change in duties or earnings) and the payment is made on account of the injury or disability.

Summary

The income tax and Class 1 NICs treatment of payments made or benefits provided on the termination of employment needs careful consideration and professional advice should be sought before any negotiations take place. The advice of an employment lawyer may be required when the drafting of any agreement and separate income tax and NIC advice should also be taken.

All employers can expect to receive a visit from employer compliance officers of HMRC at some stage and should expect the officer(s) to review the procedures for making payments and providing benefits on the termination of an office or employment. It is wrong to assume that there is an ‘automatic’ £30,000 exemption and wrong to apply this limit to ‘earnings’ for Class 1 NIC purposes.

Payments made in lieu of notice will come under the closest scrutiny and unless income tax and Class 1 NICs are deducted from all such payments, which may not be appropriate, the employer bears the risk of failing to operate PAYE. HMRC has a policy of not giving advance clearance, but some Offices will do so and remember that Statement of Practice 1 of 1994 (SP1/94) does provide for a clearance procedure where a redundancy is involved.

Paragraph 5 of Statement of Practice 1/94 says: ‘An employer or any other person operating a redundancy scheme, who wishes to be satisfied that lump sum payments under a scheme will be
accepted as liable to tax only under ICTA 1988 s 148 (now ITEPA 2003 s 401) should submit the full facts to the Inspector for consideration. Applications for clearance should be made in writing and should be accompanied by the scheme document together with the text of any intended letter to employees which explains its terms.’

MIKE EVANS

Mike Evans is Director of Employment Taxes at PKF (UK) LLP and can be contacted at mike.evans@uk.pkf.com.

The above article was first published in Tolley's Tax Guide on 12 August 2005, and is reproduced with the kind permission of LexisNexis UK.