Out-Law News 3 min. read

'Simplified' UK tax regime for termination payments could push up compliance costs, says expert

Removing the distinction between contractual and non-contractual termination payments, so that the majority of payments made to employees in lieu of notice (PILONs) are all taxed in the same way, would remove most of the "complexity and misunderstanding" in the existing system, the UK government has said.

HM Revenue and Customs (HMRC) is consulting on possible changes to the taxation of termination payments, based on recommendations made by the Office of Tax Simplification (OTS) last summer. The changes could include replacing the existing £30,000 exemption from income tax and National Insurance contributions (NICs) with a new exemption for redundancy payments only which increases proportionately with the employees' number of years' service.

"The government thinks that it is not right to have a system that is so complex that many people are not able to have certainty that they have paid the correct amount of tax and NICs when they leave a job," HMRC said in its consultation on the proposals, which closes on 16 October 2015.

Under the previous government, the OTS conducted a comprehensive review of the tax treatment of employee benefits and expenses. In its final report, published in August 2014, it made a number of recommendations for reform of the tax treatment of termination payments. The OTS said that the current system, under which the first £30,000 of a non-contractual payment may be made tax free but a PILON was taxable, was complex and also led to scope for avoidance.

"It is undoubtedly true that the current rules on taxing termination payments, whilst logical to a tax lawyer perhaps, do present headaches and risks of unintended errors for companies trying to comply with them," said tax expert Jon Robinson [link] of Pinsent Masons, the law firm behind Out-Law.com.

"Replacing the current system with a blanket rule that all termination payments are taxable, and subject to National Insurance, save for a simplified, single exemption linked to length of service and redundancy would no doubt make the rules easier to apply. But clearly, given that 'true' termination payments are currently not subject to NI at all and only taxable to the extent that they exceed £30,000 regardless of the circumstances of termination, the proposals would result in an overall tax take for the government and would in many cases push up the costs of termination for the employer," he said.

In its consultation paper, HMRC said that it had "evidence" that some employers and employees were taking advantage of some of the complexities in the existing system, for example by arguing that a taxable PILON was actually a payment for breach of contract so that there was no NIC liability and the payment was only taxable on amounts over £30,000.

"With such a complex tax treatment of termination payments it is often difficult for HMRC to disprove such claims," it said. "These employees are generally those who are well advised (and generally better paid)."

Removing the distinction between PILONs and non-contractual payments would require the existing exemptions to be revisited, both because exempting the first £30,000 of all termination payments would be financially unsustainable for the government and because the existing exemptions are linked to payments that are not earnings. The government intends to use the review as an opportunity to remove the blanket exemption entirely due to the avoidance opportunities this would present.

The most radical option suggested by the OTS in its August 2014 report was linking the exemption to statutory redundancy. However, the government does not intend to take this forward due to the large groups of workers that do not qualify for statutory redundancy. However, its preferred option is for an exemption for statutory or voluntary redundancy payments based on length of service, available to employees that had completed two years of service. To qualify for this new exemption, years worked would have to be with the same employer or an associated employer, or relate to a change of employer under the Transfer of Undertakings (Protection of Employment) Regulations (TUPE).

The government is seeking views on which of the current specific exemptions should be retained once the rules change. It is minded to retain the exemption for injury or disability, for payments to the Armed Forces and those leaving the foreign service. It is also proposing to create two new categories of exemption: for payments made in connection with wrongful or unfair dismissal, and for compensatory payments made in discrimination cases, according to the consultation.

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