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Office of Tax Simplification (OTS) proposes removal of £30,000 tax exemption for termination payments

19 August 2014

On 31 July 2014, the Office of Tax Simplification (OTS) published its final report into its review on taxation of employee benefits and expenses. It was agreed between the OTS and Treasury Ministers in 2012 that the OTS should conduct this review with the aim to simplify the legislation and improve HMRC's administration. The final report (following two previous reports in August 2013 and January 2014) has suggested the removal of the £30,000 tax exemption for compensation payments on termination of employment.

The current rules have been criticised for being misleading and confusing, leaving some people under the false impression that the first £30,000 of any termination payment will be tax free. The tax relief does not automatically apply to all payments on termination. The circumstances and nature of the payment need to be considered to establish which part, if any, is exempt from tax. It is only if the payment is not otherwise chargeable to tax, that the tax relief up to £30,000 be applied. For example, if the payment derives from the employment contract (eg notice pay, bonus, commission or holiday pay), it is taxable in the normal way as it is an "emolument of the employment". 

Proposed Changes

In the long term, the OTS has suggested the following changes:

  • The current £30,000 exemption should be replaced with a new income tax relief that is available for statutory redundancy
    It is suggested that all payments that are received in a redundancy situation (as defined by statute) would be combined and subject to an exemption up to the value of the exemption. The value of the exemption would be a multiple of the statutory redundancy payment to which the individual is entitled and would apply regardless of the nature of the payment or whether there was a right to the payment in the employment contract.  

    However, this would mean that certain termination payments that presently benefit from the tax exemption would cease to do so. These payments would include, for example, unfair dismissal awards, damages for wrongful dismissal and discrimination payments to compensate for financial loss. It is unclear whether the government will also consider exempting these payments from tax, given that they are often also paid when an individual has lost their job.

    These payments can exceed the £30,000 tax relief for termination payments and may currently be made in addition. The loss of tax exemptions on these payments would be significant for individuals, and potentially harmful for employers who might otherwise be asked to gross up such payments so that the employee receives the same amount in their hands. Details of how the proposed tax exemption would work are unclear at this stage. For example, what multiplier will apply if an individual is not entitled to receive a statutory redundancy payment?
  • The removal of existing exemptions in order to provide greater clarity
    In particular, the OTS suggests the exemption relating to death, legal costs and foreign service should be reviewed. The exemption in the case of death is thought to be no longer practically relevant, because a payment made on an employee's death is fully taxable in that it is viewed by HMRC as a payment to a retirement benefit scheme that is unlikely to have been approved by HMRC. It is thought that a review of these exemptions to determine whether they should be amended or abolished would provide greater clarity in the long term.

Alternative Solutions

The OTS report made further recommendations including:

  • increasing (rather than replacing) the £30,000 exemption in line with the retail prices index to approximately £71,000, and/or
  • replacing the current £30,000 exemption with a blanket exemption for all payments made on termination.

Even if these proposals are accepted by the Government, the OTS commented that they are not likely to be introduced in the near future. While the best way to simplify the tax treatment of termination payments would be through legislation, it is unlikely that any decisions on the proposed amendments will be made before the next general election. The Government has not yet expressed its views on these proposals.  

In the interim, it is likely that HMRC will improve its guidance on when tax relief can be applied on termination. In particular, that employers who routinely make payments in lieu of notice, without deducting tax on the first £30,000, should, most likely, be deducting tax. In these circumstances, there is most likely an implied right reserved to the employer to make a payment in lieu of notice and therefore such payment will be chargeable to tax as normal.

This article was written by Emma Bartlett, Kirsti Laird and Tom Vosper.