Prior to 6 April 2011, an employee paid a termination payment in excess of £30,000 made after the issue of the P45 could be taxed at the basic rate (i.e. 20%, by using the ‘BR’ tax code) without deduction of National Insurance contributions, provided the payment qualified under ss 401-406 Income Tax (Earnings and Pensions) Act 2003 (the Act), such as compensation for loss of office. Although, of course, it would then the employee to account to HMRC for the difference at a later date, there was an immediate advantage to the employee in terms of cashflow.
What is happening?
From 6 April, employers will have to use the ‘OT’ code when deducting PAYE from payments in excess of £30,000 made to employees after they leave their employment and are issued with a P45. This will mean that income tax will be deducted at source from post-termination payments at the basic (20%), higher (40%), or additional (50%) rates of tax as appropriate, with no personal allowance.
The regulations also enable HMRC to specify that the 50% additional rate of tax should be used by employers as a flat rate of tax, and to apply the new 0T code to pension payments received, while the employee continues to receive salary payments from an employer.
This change will be relevant to businesses that deal with various types of post-termination payments, including payments under compromise agreements and income arising under employee share plans.
When the announcement was first made, it was thought that the ‘0T’ tax code would be applied on a cumulative basis so that personal allowances would be ignored and an individual would have tax deducted at their marginal tax rate, i.e. an individual who pays tax at 40% would be subject to deduction at 40%.
However, the regulations implementing the change provide that the ‘0T’ tax code has to be applied on a non-cumulative basis. So an individual receiving a termination payment will have 1/12th of the basic rate band available and, if applicable, 1/12th of the higher rate (40%) and additional rate (50%) bands available, irrespective of his or her current level of salary.
In addition, a last-minute change has been made to retain the current 20% deduction in relation to payments connected with employee shares, options and other securities falling within Part 7 of the Act.
For a number of individuals, this change increases the risk that too much tax will have been deducted via PAYE at the time the termination payment is made. For example, an individual could pay 50% tax on any amount of a taxable termination payment which exceeds £12,500.
Those individuals will have to wait until they file their self-assessment tax return for the relevant year to claim back any overpayment and so are likely to prefer to have any payments made before a P45 is issued.
However, there are some potential advantages for higher and additional rate taxpayers. If more than one termination payment is made in a year, provided they are in different tax months, each is treated independently for PAYE purposes.
Staggering the payments may therefore result in a cash-flow advantage in that more of the basic rate band will be available. However, the key point here is that it is the date when the individual becomes entitled to the payment that is relevant for PAYE purposes, not when the payments are actually received. Also, even if only one termination payment is made, there is likely to still be a cash-flow advantage for additional rate taxpayers who are not entitled to personal allowances anyway.
Change to legal fees tax concession
Employers should also be aware that since 6 April 2011 there has been a change to the tax concession for payment by the employer of employee legal fees.
HMRC rules permit legal fees to be paid free of tax where the fees are for advice given in respect of termination of employment. This facility can often be of assistance to employer and employee, when negotiating the actual net value of a termination settlement payment. As the proposals currently stand, the HMRC legal fees tax concession will only apply to payments made through a compromise agreement and not an ACAS-brokered COT3 agreement.
We understand that HMRC have received a number of comments on the narrower scope of the new order and are currently reviewing this point. However until the point is completely clarified, it is generally advisable that any employer currently negotiating a settlement which includes a contribution to legal fees, should where possible use a compromise agreement rather than a COT3.
What should employers do?
Employers are responsible for ensuring that the correct amount of tax is deducted, or risk the possibility of HM Revenue and Customs imposing financial penalties and should ensure that they have spoken to ex-employees about the amount of tax that will be deducted from payments made to them on or after 6 April 2011.
It will be necessary to ensure that all personnel who have responsibility for negotiating termination payments are made aware of this change so that their advice to employees can be modified accordingly. Employers should also ensure that their payroll administrators are notified of the change so that they can apply the correct code from 6 April 2011.
Compromise agreements that involve terminations on or after 6 April 2011 should include appropriate wording regarding the tax deduction implications under these new rules. Also, any existing compromise agreements that make provisions for payment after 6 April 2011 may need to be checked.
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