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TAXATION OF TERMINATION PAYMENTS - (Page 1 of 3)

Where to find the law:
Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) that came into effect on 06 April 2003.

Previous law:
the previous taxation provisions were contained in the Income and Corporation Taxes Act 1988 (ICTA 1988). Schedule E applied to income tax on earnings from employment. From 06 April 2003, the employment taxation sections of the Income and Corporation Taxes Act 1988 (ICTA 1988) were repealed and replaced with provisions contained in the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). The change in the name of the Act has not affected the substantive law that remains the same. This is because currently there is a rewriting of taxation legislation, the aim of which is to make the legislation easier to understand but without changing its effect (except for minor changes): Tax Law Rewrite - Employment Income part 1.

The relevant sections are now contained in:
Part 2 of the ITEPA 2003 (Income tax: charge to tax);
Chapter 2 (Tax on employment income);
Part 3 (Employment income: earnings and benefits, etc. treated as earnings);
Chapter 1 (Earnings) and Chapter 2 (Taxable benefits: the Benefits Code).
(The above replaces (among others) s.19; s.154; and Schedule E of the ICTA 1988)

Also relevant are:
Part 6 of the ITEPA 2003 (Employment income: income that is not earnings or share-related);
Chapter 3 (Payments and benefits on termination of employment, etc) that replaces s.148 of the ICTA 1988. See: Income Tax (Earnings and Pensions) Act 2003, ss.401-416, entitled 'Payments benefits on termination of employment, etc' (that was s.148, ICTA 1988).

The phase 'taxation of termination payments' refers to payments in money or benefits which are made by employers to employees when the contracts of employment between the parties are terminated. These payments, which are made as a result of the termination of employment, are subject to provisions contained in the taxation legislation.

Note: many employers and employees believe that the first £30,000 of any termination payment is automatically exempt from tax under s.401 and s.404 of the Income Tax (Earnings and Pensions) Act 2003 - but this is not always the case. See the preliminary summary below as well as the following pages for a fuller explanation.

PRELIMINARY SUMMARY:
* the payments of lump-sums by employers to employees on termination of employment
before retirement are, with exceptions, liable to income tax. The main exception is that the
first £30,000 is normally tax-exempt. But such a payment is chargeable to tax if the
employee was contractually entitled to it because the payment was classed as earnings: EMI
Group Electronics Ltd v Coldicott (HMIT) (1999) IRLR 630, CA;

* the other main exceptions regarding tax-free lump-sum payments (which are unlimited) on
termination of employment are those -
(a) made for reason of injury, disability or death;
(b) made for long foreign service;
(c) from pension schemes (except those from unfunded, unapproved pension schemes);
(d) made for a reduction in respect of foreign service;

*settlements consisting of cash awards made by employment tribunals are tax-exempt up
to the first £30,000. Regarding the payment of income tax on such awards, the position is
that an amount equal to tax that would have otherwise have been paid is deducted in
calculating the first £30,000 (but see below: Manyservice Ltd v Wilson (1998)). The
employer normally benefits from such a reduction. Liability for NI contributions follows
tax liability;

* an employer or former employer is required to give details to the Inland Revenue and to the
former employee of any award of payments or benefits made in connection with the
termination of the employee's employment (or of any change in the duties of her or his
employment or emoluments from her or his employment) where the total amount of the
payments and benefits exceed £30,000: Income Tax (Employments) (Amendment No 2)
Regulations 1999, SI 1999/70 that is effective from 06 April 1999;

* a lump-sum payment made by an employer to an employee as a result of a compromise
agreement made 'in full and final settlement of all claims' as compensation for the
termination of the contract of employment (but which must not contain any payment in
respect of earnings or emoluments) is tax-exempt up to the first £30,000 (but see below:
Compromise agreements);

* a lump-sum payment that is paid as compensation for wrongful dismissal is paid net of
tax: British Transport Commission v Gourley (1956) AC 185 HL - 'the Gourley
principle.' In Gourney (1956), a personal injuries case, the House of Lords held that
damages for loss of earnings should be net of tax. The Court of Appeal in Parsons v BNM
Laboratories (1964) 1 QBD 95, held that the same principle applied in wrongful dismissal
cases; i.e. damages must be reduced by an amount equal to the tax the employee would have
had to pay on them. This means that an employee who has been dismissed contrary to the
terms and conditions of her or his contract of employment would receive what he or she
would have earned, together with the value of any fringe benefits to which he or she would
have been entitled, had he or she been allowed to work out the contractual notice period.
Note: the tax payable is notional tax. The reduction is not actually tax and it does not have
to be sent to the Inland Revenue so, to that extent, it represents a windfall for the employer.
The 'Gourley principle' applies to awards of wrongful dismissal up to £30,000. The reason
that notional tax should be deducted is because the employee would otherwise receive a tax-
free bonus rather than compensation for actual loss.
But note: an example of wrongful dismissal is where an employee is dismissed and given
pay in lieu of notice where there is no contractual term that allows the employer to do this.
The lump-sum payment would be compensation for breach of contract being a wrongful
dismissal. As such, the payment is not taxable as an 'emolument' but comes under s.401,
ITEPA 2003 (that was s.148 and Sch.11, ICTA 1988). Any such payment up to the first
£30,000 will not be taxable. Ordinarily, the employee is only entitled to net pay because this
is what a court or tribunal would award as damages for wrongful dismissal. That being so,
the employer but not the employee would benefit from the 'windfall' tax saving. This is in
accordance with the 'Gourney principle' whereby the employee is only entitled to be
compensated for her or his actual, that is to say, net loss. Nonetheless, it is common for
employers to make such payments gross, so that the employee benefits from the first
£30,000 tax-free. This point came up in Manyservice Ltd v Wilton, EAT Case
No.1478/98, wherein the EAT rejected the employer's argument that tax should be deducted
from an award of pay in lieu by stating: '… it is the norm - that when payments are made
in lieu of notice for monies due to the employee, payments are made without deduction of
tax. If the applicant had worked out his notice, the tax would have been deducted. If he
had not worked during his notice period, he would be entitled to be paid the gross sum
due to him for that period without deduction. This is well-established industrial practice,
in which the decision in Gourney plays no part.'

* a different rule applies where damages exceed £30,000. The leading case is Shove v
Downs Surgical plc (1984) ICR 532 QBD, wherein the Court assessed the claimant's net
losses but held that damages were to be paid gross and ordered the gross sum to be paid
that, after tax was deducted, would give the claimant the correct net award that would
compensate him for his losses. The rule, then, is that damages or compensation in excess of
£30,000 is to be paid gross: Williams v Ferrosan Ltd (2004) EAT, IRLR 607 (the EAT in
this case stated that compensation for loss of future earnings is to be paid gross, not net of
tax; but this would apply when compensation for future earnings exceeds £30,000);

* an award for 'injury to feelings' made in a discrimination case does not attract tax. The EAT
in Orthet Ltd v Vince-Cain (2004) EAT, IRLR 857 reviewed the authorities on this point
and gave these following examples as grounds for its judgment -

(a) the Court of Appeal in the Vento case (Vento v Chief Constable of West Yorkshire Police (No.2) (2003) IRLR 49; 102; Court of Appeal), when dealing at length with injury to feelings awards, did not mention the possibility of such awards being taxed;

(b) damages for 'pain and suffering, disability and loss of amenity' in personal injury cases, with which injury to feelings awards are analogous, are not subject to tax;

(c) in Walker v Adams (Her Majesty's Inspector of Taxes), Special Commissioners, (2003) STC (SCD) 269, the Special Commissioners accepted that an injury to feelings award made by the fair employment tribunal in Northern Ireland relating to religious and/or political discrimination was not taxable.

Note: the Vento (2003) case is the leading case authority for awards of injury to feelings. The guidelines for awards suggest three broad bands of compensation being:
(1) the top band should normally be between £15,000 - £25,000 and apply only to the most
serious cases, such as where there has been a lengthy campaign of discriminatory
harassment on the grounds of sex or race. Only in very exceptional cases should an award
of compensation for injury to feelings exceed £25,000;
(2) the middle band of £5,000-£15,000 should be used for serious cases which do not merit an
award in the highest band; and
(3) awards of between £500-£5,000 are appropriate for less serious cases, such as where the
act of discrimination is an isolated or one-off occurrence. In general, awards of less than
£500 should be avoided as they risk being regarded as so low as not to be proper
recognition of injury to feelings.

GENERAL TAX LAW AS IT APPLIES TO TERMINATION PAYMENTS:
how to ascertain the amount of tax payable in respect of termination payments -
this is best done by adopting a logical two-stage approach whereby you should -
* list the individual payments that make up the total sum of the termination package;
* then consider what tax provisions may apply to each individual payment.

Step 1: ascertain the facts by making a list of individual payments -
a termination payment usually consists of some or all of the following -
* unpaid salary;
* holiday pay;
* payment in lieu of notice;
* anticipated damages for wrongful and/or unfair dismissal;
* any statutory and/or contractual redundancy payment;
* any non-cash benefits such as the retention of a company car;
* any payment made to the employee by the employer for agreeing to enter into and abide by
a post-employment restrictive covenant.

It is necessary to analyse all these payments to establish whether they are made as a result of (a) an obligation arising from the contract of employment or (b) a voluntary (ex gratia) non-contractual settlement. A departing employee should ask the employer for a written account so that he or she can establish what each of the payments are for that go to make up the total termination payment. For example, a payment described as a 'redundancy payment' may consist of a statutory payment on its own or a combined statutory and contractual payment.

Step 2: ascertain which payments are subject to tax -
once all the individual payments that go to make up the total termination payment have been identified, the next step is to establish which payments are subject to a tax liability and which are exempt.

The law that applies to employees, office-holders and agency workers:
section 1(1)(a) of the ITEPA 2003 states that the Act imposes charges to tax on employment income as set out in Parts 2 to 7 of the Act. The term 'employment' for these purposes means any -
(a) employment under a contract of service;
(b) employment under a contract of apprenticeship; and
(c) employment in the service of the Crown: s.4, ITEPA 2003.

A person who is an office-holder, (e.g. a company director), comes within the 'employment' provisions by virtue of s.5, ITEPA 2003. Payments received by agency workers are treated as income from employment for tax purposes. This applies regardless of whether or not an agency worker is, in fact, self-employed: s.44, ITEPA 2003. See Agency workers

Earnings which are taxable:
section 6 of the ITEPA 2003 charges income tax on earnings from employment. Taxable earnings are defined as -
(a) any salary, wages or fee;
(b) any gratuity or other profit or incidental benefit of any kind obtained by the employee if it
is money or money's worth; or
(c) anything else that constitutes an emolument of the employment: s.62, ITEPA 2003.
Note: this definition is wider than the former law that was stated in s.19, ICTA 1988 that has now been superseded by s.62, ITEPA 2003.

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