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Changes to taxation of payments made on termination could have 'seismic effect'

Consultation to consider the government’s proposals to simplify the taxation of payments made on termination of employment has recently completed.

The proposals are likely to have a seismic effect on the settlement of disputes arising from the termination of employment.

The current position is that the first £30,000 of a payment to an employee is, generally, free of tax providing it is not contractual. This taxation “discount” has acted to help facilitate the settlement of employment disputes as it has benefited both parties. For the employee, it has increased the sum in their pocket. For the employer, it has enabled the sum payable to be reduced without any ill consequence to the exiting employee.

The consultation proposals are that all future payments related to the termination of employment will be subject to income tax and national Insurance contributions. Some notable exceptions have been proposed:

  1. Redundancy payments – but the tax-free element will be reduced considerably, see below.
  2. Payments awarded by an Employment Tribunal (ET) in respect of unfair and wrongful dismissal, and discrimination.
  1. Redundancy

The tax-free element will be significantly reduced. For redundancy, the consultation paper proposes an exemption of £6,000 for an employee with two years’ service, and an extra £1,000 for each additional years’ service. An employee with less than two years’ service will receive no tax-free allowance.

2. Unfair and wrongful dismissal and discrimination

The rationale behind making an element of these awards tax-free is that they relate to termination situations which are not the fault of the employee. A tax-free amount has not been proposed in the paper, and is likely to be subject to a cap.

Likely consequences

The proposals are likely to have at least three major effects:

  1. Employees are likely to demand increased termination packages to reflect any reduction in net settlement pay;
  2. Employers may incorrectly label a dismissal as “redundancy” in an attempt to maintain the tax advantages for both parties as described above. This may lead to increased scrutiny and incidence of prosecutions of both parties by HMRC if they find that the label is being abused;
  3. An increase in the number of claims progressing to the ET as employees have a tax-related advantage in receiving an award from an ET, which will incentivise them to make a claim and reduce the prospect of an “out of court” settlement.

While the government’s intention is to simplify the tax rules, the proposals, if enforced, will dramatically reduce the tax free exemption that many departing employees currently enjoy. Diluting this exemption will almost certainly increase employment legislation, particularly since the current proposals offer a tax advantage to those prepared to take a claim to the ET. It is surely not the intention of the legislators to increase the workload of the courts, and this seems to fly in the face of various changes that have been made to reduce Tribunal claims.

While we wait for the government to announce any decisions on the proposals, we may well see an increase in the number of tax-free settlement payments over the next few months as employers seek to take advantage of the exemption before its anticipated removal.

Chris Marshall is an employment solicitor at Spring Ferguson, a division of Spring Law.