Are You Liable To Tax On The Termination Package Offered In Your Compromise Agreement?

Since most compromise agreements contain an indemnity clause placing the burden on

the employee to pay any tax on any gross payments received under settlement terms contained in a compromise agreement, it should be an important consideration for every employee.

The purpose of this article is to provide some general guidance on whether tax is likely to be payable or not and in doing so help you to properly evaluate the suitability of an employer's termination package, particularly if you are a higher rate tax payer, since after you have taken any tax liability into account, you may decide that the termination package on offer is neither attractive nor adequate. Please bear in mind however that the guidance I provide here is simply that, guidance only to current judicial thinking and understanding. Ultimately, it is for the Revenue (HMRC) to determine on a case by case basis whether tax is due in respect of a termination payment.

It's very important to get the taxable position on payments made under compromise agreements right. Most people have heard that the first 30,000 can be paid free of tax, but that is not always the case. The 30,000 tax exemption only applies to the compensation element of the severance/termination payment. So, if your termination payment has several components such as "payments in lieu of notice" (PILON), holiday pay and any other wages and emollient entitlements pursuant to your contract of employment, this will be taxable in the normal way and ought to be deducted by your employer and paid to you net of tax.

The taxable treatment of a severance payment will depend on how the payment is made up. If the severance or termination payment is made up of payment in lieu of notice, unpaid holiday pay, for example, tax is chargeable on those components of the severance payment. It is therefore possible to improve the tax position by negotiating and re-arranging the way payments are expressed within the Compromise Agreement. To ensure that you maximize the use of the current 30,000 exemption to tax, it is advisable to obtain professional advice so that your employment contract and any other relevant documentation can be properly considered.

As you will appreciate, it would be inaccurate to assume that all termination payments up to 30,000 are tax free, an assumption that is all too often made by many employers. It would therefore be prudent to exercise some caution before concluding agreement on the terms of any termination payment in order to avoid receiving an unexpected tax bill. For ease of reference I have set out below some of the most common components of termination payments and given an indication of whether tax may be chargeable:

1. Statutory redundancy payments are included as part of the tax-free 30,000 exemption.

2. Contractual redundancy payments are paid free of tax up to the 30,000 limit, as long as its for genuine redundancy.

3. Compensation for loss of employment which may be referred to as ex gratia payments, are exempt of tax up to 30,000.

4. Payments in lieu of notice (PILON) may be subject to tax if an employee's contract contains this the right for the employer to terminate. If a PILON clause is not contained in the contract then this payment is unlikely to attract tax unless it can be shown that there existed a custom of the employer to make PILON payments. HMRC Guidance however, has clarified that if a PILON is habitually paid as part of the process of termination, the payment will be treated as compensation and not subject to tax.

5. Payments offered in return for an employee agreeing to post termination restrictions such as non-competition and which are not previously covered in the employee's contract of employment are specifically taxable if a specific payment is assigned to it.

If you are presented with a financial package for the termination of your employment, it is advisable not to agree anything but to simply ask your employer to put it in in writing for your further consideration. This will allow you further time to think carefully about the offer. If you are a higher rate tax payer and the severance package exceeds 30,0000, try to ensure that your payment is received after your p45 as the balance over 30,000 threshold will be taxed at only 20% and you will have a further year to pay any taxed owed. You may also consider asking for part of your termination payment to be paid directly into your pension as this is treated separately and will not be included as part of the 30,000 tax exemption.

by: Graham Cardona

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