Severe tightening of PAYE treatment of post-termination payments

As of 6 April 2011, the PAYE treatment of post-termination payments has changed.

Before 6 April 2011, if a termination payment was made after the termination date and the issue of the P45 and is taxable (that is, it does not fall within the £30,000 exemption), then the employer had to use the BR tax code for PAYE purposes. This means that the employer only had to deduct tax at the basic rate (currently 20%). The employee had to declare the amount of the termination payment in their tax return for the relevant tax year, and pay any further tax due. While this did not change the actual amount of tax due, it had obvious cashflow advantages for employees who paid tax at the higher (40%) or additional (50%) rate.

From 6 April 2011, employers must use the 0T tax code, rather than BR, for all post-termination payments not included in a P45. The overall amount of tax will remain unaffected, but higher or additional rate taxpayers will find that a much greater amount of the tax due will be deducted from their termination payments than was previously the case.

The practical effect of the change will be that employers will no longer be able to offer a cashflow advantage when negotiating a compromise agreement

The regulations state that the 0T tax code is to be applied on a 'non-cumulative' basis. For an employee paid on a monthly basis, this means that only 1/12th of the basic rate band (and, if relevant, 1/12th of the higher rate (40%) band) is available in the month of payment. This will mean that if the termination (or other) payment is more than the appropriate proportion of the 20% band, the excess will be taxed under PAYE at 40%, and if the payment is also more than the available 40% band, the excess will be taxed under PAYE at 50%.

For example, the PAYE that has to be applied to any post-P45 payment in the first month of the 2011-12 tax year (month 1) will be roughly as follows:

  • The first £2,916.67, or the whole payment if it is less than this amount, is taxed at 20%, which means a PAYE deduction of up to £583.33 (£2,916.67 is the 20% band for 2011-12 for month 1, found by dividing by 12 the 20% band for the year, £35,000).
  • The next £9,583.33 is taxed at 40%, which means a PAYE deduction of up to £3,833.33 (£9,583.33 is the 40% band for month 1, found by dividing by 12 the 40% band for the year, £150,000 - £35,000).
  • Any amount above £12,500 is taxed at 50% (£12,500 is the combined 20% and 40% bands for month 1, found by dividing £150,000 by 12).

This would mean that if, after 6 April 2011 and the issue of the P45, an ex-employee receives a termination payment:

  • Of £10,000, £3,416.66 would be withheld as PAYE (compared to £2,000 under the pre-6 April 2011 BR tax code).

The PAYE is calculated as follows:

£2,916.67 @ 20% = £583.33

£7,083.33 @ 40% = £2,833.33

Of £20,000, £8,166.66 would be withheld as PAYE (compared to £4,000 under the pre-6 April 2011 BR tax code).

The PAYE is calculated as follows:

£2,916.67 @ 20% = £583.33

£9,583.33 @ 40% = £3,833.33

£7,500 @ 50% = £3,750

Employers should ensure that their payroll operators are aware of this change, so that they can operate the 0T code if necessary. They should also ensure that their HR function is aware of the change, so they don't automatically delay payment until after the issue of the P45. They may also need to communicate the change to ex-employees who may have been informed that post-P45 payments would be subject to basic rate tax withholding.

Indeed, the employee may suffer a number of disadvantages if the termination payment is made now and the P45 has already been issued.

Firstly, the employer will have to operate PAYE on the basis that none of the personal allowance is available (while this is the current position in the BR basis, it is mitigated by the cash-flow advantage of a 20% deduction rate).

Secondly, 'monthly' means tax, rather than calendar, months. Tax months run from the 6th of one calendar month through to the 5th of the next (as each tax year starts on 6 April). This means that payments made on, say, the 7th of one calendar month and the 2nd of the next would fall within the same tax month, with the effect that only one month's bands would be available to share between the two payments.

Finally, the change increases the risk that the amount of PAYE deducted is more than the actual income tax liability. If the employee has little other taxable income in the tax year, they could have too much PAYE deducted from the termination payment and have to reclaim some tax through their tax return.

The practical impact of this change is that, from 6 April 2011, it will no longer be the case that a cashflow advantage will generally arise from making payments after issuing the P45. Instead, the relative merits (from a cash-flow perspective) of pre- or post-P45 payment will need to be assessed individually in each case.

Robin Davis is a consultant at Bray & Krais Solicitors