On 24 July 2015 the UK issued a consultation document in respect of the reform of income tax and national insurance on termination payments by employers. This follows a report from the Office of Tax Simplification on ways in which the complexity of the current exemptions could be reduced and fairness increased for employees.

A termination payment may be made up of several different elements such as statutory redundancy pay, holiday pay, payment in lieu of notice (PILON) or an ex gratia payment for loss of employment. Some elements of the termination payment may be exempt from tax and national insurance. There is an exemption for the first GBP 30,000 of the elements of the termination payment that come within certain categories, however these only apply if the payments are not part of salary or provided for in the contract.

Currently the parts of a termination payments that arise from the employment or which the employee is contractually entitled to are not exempt but subject to income tax and national insurance in the same way as other employment income.

The Office of Tax Simplification report suggested that the complexity of the current system led to employers paying the wrong tax on termination payments and also led to tax planning that favoured people who could afford the best tax advice. The system was therefore unfair and discriminated against people who could not afford the advice. Employers make mistakes in computing tax due and sometimes employees have been asked for more tax than they initially believed would be payable. HMRC has some evidence that employers change the categorization of payments to save tax and national insurance for the employee and save employer’s national insurance.

The UK government aims to reform the taxation of termination payments so they are simpler to understand; provide certainty for employees about the tax and national insurance treatment; and are fair and easy to administer. The changes must also be affordable for the UK government.

The consultation document suggests that the distinction between contractual and non-contractual payments will be removed, for example so that all payments in lieu of notice are treated in the same way. All payments for termination of employment would be subject to income tax and national insurance. However a new exemption would also be introduced.

Also, the income tax and national insurance treatment of termination payments would be aligned to provide further simplification. This would make the treatment fairer and easier to administer. Views are invited on this alignment.

The UK government is considering introducing a new exemption that would increase in proportion to the number of years of service that the employee has completed with the same employer (or an associated employer such as another company in the same group). This would be easy to understand and easy for employers to administer.  An employee would qualify for this exemption after two years of service, and the amount of the exemption would increase at a predetermined rate for each year of service up to a maximum amount.

The UK government is also looking at the possibility of providing the tax relief only where the termination payment is connected to redundancy of the employee (as defined in section 139 of the Employment Rights Act 1996). The relief would therefore apply where the employer ceases to carry on business for the purposes for which the employee was employed; ceases business at the location where the employee is working; has less need or no need for the employee to carry out the particular kind or work; or the need to carry out that kind of work at that particular workplace has diminished or ceased. The definition would include voluntary redundancy.

The government is inviting views on the level of the threshold for the tax relief for termination payments; and views on basing the relief on the length of service of the employee.

The legislation would include anti-avoidance provisions. These would ensure that the relief cannot be used by employers to provide tax free remuneration, for example by an agreement at the start of an employment for salary sacrifice in exchange for a tax free termination payment. Further anti-avoidance provisions are under consideration, for example denying the exemption for employees on a fixed term contract or where it is agreed that the employment will end after a fixed period of time. There would also be provision for the payments to become taxable if the employee is re-engaged to do a similar job for the same company or an associated company within a twelve month period.

The existing exemption from tax and national insurance on termination payments connected to injury or disability and for termination payments by the UK armed forces would be retained.  Also, payments that would normally be exempt from tax if paid as part of salary would continue to be exempt if paid as part of a termination payment (for example payments into a registered pension scheme).

If the exemption is restricted to termination payments in connection with redundancy two new exemptions would be introduced. There would be an exemption for payments in connection with wrongful or unfair dismissal and an exemption for compensatory payments for discrimination.