The £30,000 exemption only applies to payments made on the termination of the employment that are not payments of earnings.
Therefore, in deciding whether an element of the termination package is covered by the £30,000 exemption (and thus free from tax), the first step is to consider whether that payment is a payment of earnings.
How is This Determined?
Payments of earnings are generally those payments that are normally made as part of the employment. This would include payments under the employment contract, such as wages and salary, and also payments which it is customary to make and which the employee expects to receive, even if not specifically provided for in the employment contract.
Payments that are earnings remain payments of earnings when made on termination, and as such are taxable in full. The £30,000 exemption is not in point.
However, the £30,000 exemption does apply to other payments made on termination, for example to compensate the employee, either for the loss of his or her job or the failure to give proper notice. These payments are not earnings and, to the extent that the £30,000 exemption has not already been used up, may be paid free of tax.
A termination payment typically comprises a number of elements. These may include:
• Normal wages or salary
• Payment in lieu of notice
• Redundancy payments
• Compensation payments, and
• Holiday pay
It is important that each element is considered separately, rather than trying to ascertain the tax position of the payment as a whole.
This is a case where it is necessary to look at the sum of the parts.
Wages & Salaries
Payments of wages and salaries are normal payments of earnings payable under the employment contract. These are taxed as earnings and do not benefit from the £30,000 exemption.
Payments in Lieu of Notice
The treatment of payments in lieu of notice (PILONs) can be tricky because the term is often used loosely to describe payments of varying characteristics. It is the characteristics of the payments that will determine whether or not it benefits from the £30,000 exemption.
A PILON is made when an employee is not given the full notice to which they are entitled and is given a payment instead. Where contractual provision is made for the making of a PILON or it is customary for a PILON to be made, HMRC regard the payment as `flowing from the employment’ and tax it as earnings, thereby denying the benefit of the exemption. However, where an employer fails to give an employee proper notice and pays damages for that breach, the payment is not earnings and can be made tax-free up to the £30,000 limit.
PILONs are often confused with gardening leave. In a gardening leave scenario, the employee is simply paid his normal wages and salary for the notice period but is not required to work his notice.
The wages and salary are taxed in the usual way. Similarly, if an employer pays off accrued holiday, again this is a payment of the earnings and taxable in full.
Redundancy payments, whether statutory or non-statutory, are regarded as compensation payments. This is good news as it means that payment can be made tax-free up to the £30,000 limit.
The £30,000 limit applies per termination. Payments qualifying for exemption are only tax-free to the extent that the limit has not been exceeded. To the extent that qualifying payments exceed £30,000, these are taxable.
When structuring a termination package, try and make best use of the £30,000 exemption by making compensation payments rather than payments of earnings where at all possible. Care should be taken when drafting the employment contract.
By Sarah Bradford