Compensating a departing director or employee

What’s the payment for?

The tax tribunal recently issued a ruling in the case of a senior employee who was paid a substantial sum following the termination of her employment. The tax position was tricky because the taxpayer argued that the money she received was for personal damages that would have made it entirely tax and NI free. Even in more mundane circumstances, deciding on the tax and NI position for termination payments is often challenging for employers.

Is it taxable?

Payments made in connection with the termination of employment (including directorships) are taxable. In some circumstances they are taxable and liable to NI contributions in the same way as salary. In other circumstances special rules apply to make it taxable except for the first £30,000 which is exempt from tax and NI contributions. However, the exemption isn’t as straightforward as it might seem at first sight.

It’s up to you as an employer to apply a special formula to work out if and how much of a termination payment constitutes a payment in lieu of notice (PILON) and deduct tax and NI on that part as if it were salary. The £30,000 exemption might apply to the remainder.

Does the exemption apply?

Even after deducting the PILON the balance of a termination payment doesn’t automatically qualify for the exemption. It applies only if the payment is “for” the termination and not just “because” of it. For example, a lump sum paid to a director because their contract says they are entitled to one is payment because of the termination and not for it. Similarly, an entitlement to accrued sums, such as bonuses, even if they aren’t mentioned in a contract, are because of termination and not for it.

Non-exempt payments

Tax and NI payable can push up the cost to you as the employer because the director will negotiate harder for a larger sum to account for what they lose in tax.

As illustrated by the Tribunal case, HMRC often goes after employers who apply the £30,000 exemption. To avoid being hit with the tax and NI cost of losing the exemption it’s essential to show HMRC that you have taken reasonable care that it applied.

Keep a record of the HMRC guidance you followed in deciding whether the £30,000 exemption applies. That way, even if ultimately HMRC proves you took the wrong course of action, it’s likely to ask the former employee or director to pay the extra tax.

In correspondence with a departing employee or director it’s important to describe payments accurately. Saying that it relates to lost earnings or in recognition of past services indicates that the £30,000 exemption doesn’t apply. Refer to it as a payment in relation to the termination of employment.