March 2016: Injury to Feelings Compensation Payment Taxable as Termination Payment: The Upper Tribunal (Tax Chamber) has held that a settlement payment for injury to feelings made in connection with a termination of employment was taxable as a termination payment. The payment was made to settle all the taxpayer’s claims against the employer, including claims for age discrimination arising during the redundancy selection process. This decision confirms that the tax treatment of compensation for discrimination depends on whether the discrimination is connected with the termination.

Compensation for discrimination that occurs solely during employment (even if paid on termination) is neither earnings nor a taxable termination payment and can be paid without deduction of tax. However, compensation for discrimination connected with the termination will be taxable as a termination payment. The Upper Tribunal also determined that the tax exemption for compensation paid on account of “injury” did not include compensation for injury to feelings. Employers must apply this interpretation of injury when deducting tax from the compensation payment (in excess of the £30,000 exempt amount). Otherwise, employers risk HMRC seeking under-deducted tax from them rather than the employee.

August 2015: Tax Treatment of Discrimination Payments.The First-tier Tribunal (Tax Chamber) has held that a payment to an employee under a compromise agreement was made to settle an existing potential race discrimination claim and did not, therefore, constitute taxable earnings. The employee’s potential claim related to the level of his bonuses and salary increases during his employment.

This is the first decision to consider whether discrimination payments that are calculated by reference to loss of earnings are taxable as general earnings. However, businesses need to be cautious about relying on the decision, as it appears to be at odds with HMRC’s long-standing practice.

This business briefing summarises how termination payments are taxed. Termination payments are severance payments to employees on termination of their employment. They can arise in a number of ways, for example, in connection with dismissal or constructive dismissal, redundancy, retirement, or departure because of disability.

Termination payments must be taxed correctly

  • HM Revenue & Customs (HMRC) can recover unpaid tax, national insurance contributions (NICs), penalties and interest from the business if termination payments are not taxed correctly
  • A business should consider both income tax and NICs. In addition to employee’s NICs, the business must pay employer’s NICs on payments that constitute earnings from employment. This can add significantly to the costs of settlement
  • If the business does not deduct tax or NICs from a termination payment it will be generally liable for the tax and NICs not deducted, plus interest and penalties. A failure to deliver PAYE returns on time (or at all) may lead to more penalties
  • Both the business and its former employee will want the termination payment to be legitimately structured to:
    • reduce the tax liability, and
    • increase the certainty that no future liability will arise

How much of the termination payment is taxable? How much of a termination payment is taxable will depend on the nature and amount of the payment. Payments fall into a number of categories including:

  • Sums that the employee was contractually entitled to, or that were connected with, past or future service. These are generally taxable in full and include:
    • salary payments
    • contractual bonus or commission
    • contractual payments in lieu of notice (PILONs), and
    • automatic PILONs
  • Consideration for entering into restrictive covenants. This is taxable in full
  • Non-contractual payments made as a result of the termination and redundancy. The first £30,000 is tax-free. These include:
    • damages for wrongful dismissal and payments on account of damages
    • compensation for unfair dismissal
    • compensation for discrimination made in connection with the termination to compensate for financial loss
    • payments of statutory and non-statutory redundancy, and
    • non-contractual benefits in kind provided on termination
  • Payments where termination results from a disability or from a discrimination claim not connected to the termination. These are tax-free without limit
  • Share options and share awards. Employees may be entitled to exercise share options and receive share awards either before or at some point after termination. The tax and NICs liabilities will depend on a number of factors, including:
    • whether the scheme is HMRC approved
    • the length of ownership, and
    • the reason for cessation of employment
  • A cash cancellation or compensation payment will be fully taxable.
  • Employer contributions to registered pension schemes. These may be made tax free, subject to the annual contribution limit provided that they do not represent sums to which the employee was contractually entitled.

National Insurance Contributions: NICs are generally payable for all termination payments that the employee is entitled to under their employment contract. HMRC may argue that NICs are payable where there is an established practice of making termination payments, even where there is no express contractual right.

Tax-free benefits that can be provided to employees: Provided that payment is made directly to the provider of the service, the following services can be made available to an employee without attracting tax:

  • Legal fees in connection with a compromise agreement
  • Outplacement counselling
  • Re-training

The content of this Business Briefing is for information only and does not constitute legal advice. It states the law as at March 2016 We recommend that specific professional advice is obtained on any particular matter. We do not accept responsibility for any loss arising as a result of the use of the information contained in this briefing.