This post was written by Fionnuala Lynch.
From 6 April 2011 the PAYE treatment of termination payments to an employee after a P45 has been issued will change. Any employers considering the timing of any imminent dismissals should consider whether it may be better to enter into any compromise agreement or other termination agreement before the end of this tax year. This will not change the actual amount of tax due but will have cash flow advantages for employees on higher rates of tax. As regards payments to be made after 6 April, employers should consider whether it may be better to make the entire payment before the issue of the P45 or structure the payment monthly, post P45.
Pre 6 April 2011
The Income Tax (Pay As You Earn) Regulations 2003 (the “Regulations”) govern the treatment of post-P45 termination payments through the PAYE system. Prior to 6 April 2011, for PAYE purposes, if a termination payment is made after the employment has ceased and a P45 has been issued, any taxable income (that is, income which does not fall within the £30,000 exemption) is subject to the BR (basic rate) PAYE tax code. This means that the employer only has to deduct 20% basic rate of tax thereby giving higher (40%) and additional (50%) rate tax payers a temporary cash flow advantage.
Post 6 April 2011
From 6 April 2011, the Regulations are being amended to enable code numbers to take account of the 50% additional rate of income tax. In addition, certain related changes are being made, which will mean that income tax is paid earlier than at present. If a termination payment is made after the issue of a P45 and is taxable, then the employer must use the 0T code (zero allowances) on a “non-cumulative” basis rather than the BR code. The ‘0T’ code will deduct income tax at the basic, higher and additional rates depending on the level of income in question, without giving any personal allowances. Software providers will in most cases have made the necessary changes to payroll software to enable the new OT rate to be applied.
As a result of lobbying, these changes may not now apply to all taxable post-P45 payments. The PAYE treatment of post-P45 rewards of shares, options and other securities listed under Part 7 of ITEPA 2003 should not be affected and may still be subject to BR tax code and taxed at 20%.
There is a commonly held view that a severance agreement should be signed only after termination in case HMRC regards the severance payment as consideration for agreeing a variation in the contract or staying in employment, and therefore taxable. However, provided that the agreement is not signed more than two or three months before termination and the employee is receiving the full notice entitlement (or a separate payment in lieu of the remainder of the notice), it is unlikely to be challenged by HMRC as they will regard it as a payment in connection with the termination in accordance with s. 403 ITEPA 2003.
The £30,000 redundancy payment exemption
The first £30,000 of a redundancy payment will be exempt from tax under s.403 (1) ITEPA 2003 whether it is paid before or after the issue of a P45.
If a termination payment falls below the £30,000 threshold, the payment should not be included on a P45 and HMRC need not be notified.
If and to the extent it falls above the threshold and is made:
- on or before termination (or before the P45 is issued, if later) the taxable amount should be included in the gross pay in the P45 and the employer should notify HMRC accordingly;
- after termination and issue of the P45, the employer should not issue a further P45 but should use the 0T code for taxable income (i.e. income over £30,000). The employer should write to HMRC advising them of the amount and date of the lump sum and the amount of tax deducted.
The written report must be made by 6 July following the end of the tax year in which employment terminated, that is, at the same time as the P11D. However, it can be made earlier. A copy should be given to the employee.
Does the Ex- Employee Have to Complete a Self-Assessment?
The ex-employee should notify his local tax office of receipt of any taxable termination payment. HMRC will then decide whether a self-assessment needs to be completed.
Should Termination Payments be made pre or post P45?
As a general rule, employers should make termination payments before issuing the P45 to avoid a basic rate taxpayer having to reclaim overpaid tax. Alternatively, the post-P45 payments could be structured to be paid monthly which would provide a temporary benefit to higher and additional rate taxpayers.
Please find below an estimate of the largest cash-flow tax benefits potentially available within one tax year if the termination payment was structured monthly:
- For an additional rate (50%) taxpayer: £20,166
- For a higher rate (40%) taxpayer: £6,416
However, a basic rate taxpayer would suffer a maximum temporary disadvantage of £8,666. For further information on this, or any other tax related topic, please contact Reed Smith tax counsel Fionnuala Lynch.