Sarah Bradford provides an overview of the payments that may be made on the termination of an employment contract and how they should be treated for tax and NI purposes.
As the coronavirus job retention scheme starts to wind down, employers are faced with the difficult decision as to which employees they can bring back to work and whether they need to make any employees redundant.
Normal payments vs termination payments
When an employee is made redundant, there are various payments which may need to be made. Broadly, they can be split into normal payments and payments that the employee receives as a result of the termination (the termination award).
Normal payments are those made to the employee in the general course of their employment including wages, salary and accrued holiday pay. These are treated as earnings from the employment and liable to tax and NI when paid on the termination of employment as if they had been paid to the employee while the employment was ongoing.
Payments made specifically on the termination of employment make up the termination award. This may include pay in lieu of notice, compensation for loss of office, statutory redundancy pay, and non-cash benefits. Items included within the termination award may be taxed either as earnings or under the specific rules applying to termination payments in ITEPA 2003, Pt. 6, Ch. 3.
The £30,000 tax-free allowance only applies to payments that are taxed under the termination payment rules.
Taxation of the termination award
The first step is to find the relevant termination award by excluding any statutory redundancy pay to which the employee is entitled (or an equivalent amount paid under a contractual redundancy scheme).
Statutory redundancy pay, or equivalent contractual redundancy pay, is taxed as a termination payment under the rules in ITEPA 2003, Pt. 6, Ch. 3 and benefits from (and counts towards) the £30,000 tax-free threshold.
The relevant termination award is taxable as earnings up to the level of an amount known as the post-employment notice pay (PENP).
The calculation of the PENP can be quite complex and I will explore it in the second article in this series. Broadly the PENP is equal to the amount that the employee would have earned had they worked their notice period. Amounts taxed as earnings are included in gross pay for PAYE and class 1 NIC purposes.
Where the relevant termination award is more than the PENP, the excess is taxed as a termination payment and benefits from the £30,000 threshold to the extent that it has not already been used (for example, by statutory redundancy pay). Where amounts taxed under these rules exceed £30,000, the excess over £30,000 is taxable.
Statutory redundancy pay
An employee who has at least two years’ continuous employment when they are made redundant qualifies for statutory redundancy pay. This must be paid by the employer. Where the employer operates a contractual scheme, the amount paid must at least equal the statutory redundancy pay to which the employee is entitled.
The amount of statutory redundancy pay depends on the length of the employee’s service, their age when made redundant and the level of their wages. Employees are entitled to:
- one and a half week’s pay for each full year that they were aged 41 and over;
- one week’s pay for each full year that they were 22 and older but younger than 41;
- half a week’s pay for each full year that they were under 22.
Service is capped at 20 years for the purpose of the calculation, and is counted back from the date that the employee was made redundant.
For 2020/21, pay is capped at £538 per week, meaning the maximum statutory redundancy payment for 2020/21 is £16,140 (20 years @ £538 per week x 1.5 weeks).
Where an employee is made redundant after being furloughed, time on furlough counts as part of the employee’s continuous service. Further, statutory redundancy pay should be worked out using the employee’s usual pay (generally the pay on which the furlough claim was based) rather than any lower amount that the employee received while furloughed.
Payments made on the termination of employment which are treated as earnings are liable to employee and employer class 1 NIC and should be included in gross pay for national insurance purposes.
No national insurance liability arises on amounts covered by the £30,000 threshold. However, since 6 April 2020, where amounts taxed as termination payments exceed £30,000, the excess is liable to class 1A NIC. No employee contributions are due on amounts taxed under the termination payment rules.