The assumption that the first £30,000 of a termination payment to former employees will be tax-free is an important basic principle for both employees and employers. However, over the past year, this tax-free payment has been under threat.
Admittedly, there have always been limitations to this basic principle. For example, it can only be made:
as a terminal bonus referable to past achievements;
in lieu of notice in accordance with a contractual entitlement;
under a liquidated damages clause;
in consideration for new restrictive covenants.
It is this last example which has caused concern for employers and their departing employees. Payments for restrictive covenants are taxable in relation to an employee undertaking which “restricts the individual's conduct or activities”.
Recently, certain tax offices have been interpreting this in such a way that most termination payments paid in accordance with a severance agree- ment were potentially taxable.
It is very common for termination payments to be paid under a severance agreement, often in the form of a compromise agreement.
An important element of the severance agreement is that the termination payment is accepted in full and final settlement of any claims the employee may have against an employer and, in some cases, that they will either withdraw or not begin proceedings.
Some tax offices have viewed this agreement as constituting a restriction on the employee's future conduct and have taken the whole of the termination package as taxable.
The Inland Revenue has now clarified the situation by issuing a statement of practice which confirms that, in the future, no chargeable value will be attributed to these “full and final” undertakings.
However, the position remains that payments for any other restrictions are taxable. This certainly includes new restrictive covenants, but may also include agreements:
to comply with restrictive covenants in the employment contract which would otherwise be unenforceable due to an employer's breach of contract;
not to make derogatory statements about the employer; or
to keep the terms of the severance agreement confidential.
It is important to remember that if the employer does not deduct any income tax due before making the payment to the employee, the Revenue will claim the unpaid tax from the employer, with the possibility of interest and penalties being added. To avoid this, the employer may seek prior clearance from its tax office before making the payment, or, alternatively, provide for such a charge to be recoverable from the employee under an indemnity in the severance agreement.
Despite the Revenue's statement of practice, there is still concern that some local inspectors are seeking to tax payments in lieu of notice as a contractual entitlement where the company's practice has been to pay these on a regular basis. This is despite the fact that there is no entitlement in any contract.
The Revenue's argument is that it has become an implied term by custom and practice. Once again, prior clearance would be advisable.
There has been much speculation that the Revenue's approach to the interpretation of tax legislation might be the first step towards the withdrawal of tax-free payments on termination and hence destroy the “golden” part of the handshake. Despite speculation, however, this was not one of the cost savings announced in the Budget.