Mark McLaughlin CTA (Fellow) ATT TEP outlines the potential tax treatment of payments made on the termination of an individual's employment.

Introduction

An unfortunate consequence of the economic climate is that more people will find themselves out of work. At least there is an Income Tax exemption for statutory redundancy payments (ITEPA 2003 s 309). Non-statutory redundancy payments are charged to tax under ITEPA 2003 s 401, subject to various potential exceptions including the first £30,000 under ITEPA 2003 s 403, and no Class 1 NIC.

HMRC generally tend to look closely at claims for the £30,000 exemption following the termination of an employment. The Employment Income Manual states (at EIM 13750): “It is vital to identify redundancy payments properly because…what people call redundancy payments may not fall within the special definition of redundancy…” (nb ‘special' means the definition of redundancy in the Employment Rights Act 1996 s 139). It is therefore necessary to consider if HMRC could actually treat the payment differently for tax purposes e.g., as employment income (except for statutory redundancy payments), or possibly as an employer-financed retirement benefits scheme (ITEPA 2003 s 394).

Employment earnings or damages?

For termination payments other than for redundancy, in terms of claiming exemption for the first £30,000 of such payments, the general approach for employers should be to terminate the employment first, and agree a financial settlement later. A key question is whether a payment is made under the employment contract (i.e., earnings) or is damages for breach of contract.

If the employee has the contractual right to receive pay in lieu of notice (a PILON), case law has established that this also constitutes earnings, even if it is paid on termination of employment. This would appear to be the case even if the PILON is payable at the employer’s reserved right or discretion (EMI v Coldicott [1999] STC 803 CA and Richardson v Delaney [2001] STC 1328). In the latter case, the employee had accepted a lump sum of £75,000 following negotiations with the employer, which was held to constitute earnings.

By contrast, a termination payment following a breach of contract was held to be damages even though the employer had the right to make a PILON which was not exercised in Cerberus Software v Rowley (CA, [2001] EWCA Civ 78). In that employment law case, a contractual clause stated that the employer ‘may' make a PILON. The Court held this to mean that the employer was free to give neither notice nor a PILON but instead to breach the contract. The payment was therefore damages, which qualified for the £30,000 exemption, and was not earnings so that no NIC liability arose.

Clarifying the position

If an employer terminates in breach of the employment contract, such as by dismissing the employee without notice, and does not make a PILON in respect of that notice period, a payment subsequently made to the employee is generally more in the nature of damages than employment earnings. It therefore follows that the chances of a compensation payment constituting damages may be enhanced broadly if:

• The employer breaches the employment contract by breaching the notice period and failing to make a PILON;
• The employer does not make any payment for breach of contract until after the employment has terminated;
• Correspondence and documentation between the employer and the employee indicate that the employee’s claim is for damages for breach of contract. 

Two final points are worth mentioning. First, be aware of HMRC’s approach to termination and damages claims. This is contained in Revenue Interpretation 249 and in the Employment Income Manual at EIM12800 and following. Second, be aware of the legal issues involved when terminating an employment, and seek advice from an employment law specialist if necessary.    

The above article is reproduced from ‘Practice Update' May/June 2009), a tax Newsletter produced by Mark McLaughlin Associates Ltd.

Article Added Saturday, 03 October 2009 | 2696 Hits

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