Under section 401 of the Income Tax (Earnings and Pensions) Act 2003 ("ITEPA 2003"), the first £30,000 of certain termination payments are free from income tax.
There is a common misconception though that the first £30,000 of any termination payment can be paid tax free. Like many things in life it is not quite as simple as that.
A termination payment only enjoys such favourable tax treatment if it is not made under the contract of employment (the exception being contractual redundancy payments which can be paid tax free up to £30,000). Therefore any payment in lieu of notice ("PILON") made to an employee, which is expressly provided for under the contract of employment, will be subject to income tax. Payments made to the employee to compensate them for loss of office and which the employer is not obliged to make under the contract of employment, are free from income tax up to the first £30,000. Complications can arise though if there is a custom and practice of always paying in lieu of notice even if there is no PILON clauses, if there is a discretionary PILON clause and if the payment is an early retirement payment.
A recent report by the Office for Tax Simplification (the "OTS") has, among other things, examined the current system for the taxation of termination payments and considered whether it requires simplification.
Unsurprisingly, the report by OTS has identified that many employers and employees are confused over the operation of section 401 of ITEPA 2003 and are unsure of exactly when a termination payment is subject to income tax. The OTS recognises the common misconception I have identified above and also makes the point that many believe that the basis for the different treatment of PILON payments made under the contract of employment and any other termination payment is not fair because employees rarely have control over the wording of their contract and that "there is a strong feeling that this inequality of treatment needs to be addressed and that the tax treatment should not be dependent upon the wording of the employee’s contract."
There has also been concern expressed over the level of the exemption which has not increased from £30,000 since 1988. The report identifies that on the basis of the retail price index, today's level of exemption would be £71,000. According to the report some employers and advisers are in favour of an increase to the value of the exemption and others suggest that it should be linked to length of service in order to give it greater meaning and give more recognition to the contribution that the employee has made to the business. Others believe that all PILONs should be made tax free because it is a payment to compensate an employee for loss of office.
The report concludes that there is scope for simplifying the law around this area and that the policy behind the exemption has become unclear and requires to be reviewed.
To read the full report, click here.