Settlement Agreements have been once again on the up; probably due to businesses deciding to restructure before the end of the financial year on 31 March. As a result, many employers are facing the most common query from employees: who should pay the tax due on their Settlement Agreement?
This is because Settlement Agreements require employees to indemnify their employers against any further excess tax which may be due.
In most cases, the compensation amounts to less than £30k, which is the taxation threshold, and is offered in one lump sum. However, the employer will sometimes include in this compensation payment, a number of contractual payments such as holiday pay and notice. Strictly speaking these are taxable payments.
It used to be accepted that if the employee did not have a Payment in Lieu of Notice (PILON) clause in their contract, their notice pay could be paid tax free, as a gross figure. This is because paying in lieu, when there is no contractual right to do so, is technically a breach of contract.
Recently we have encountered a growing number of more cautious employers who are not willing to rely on the lack of a PILON clause to pay a grossed-up notice payment. Also, it has become more common for large employers to reach agreement with HMRC to always tax notice payments that are being paid in lieu – ensuring maximum revenue for the state.
But there are some employers that wish to maximise their employees’ severance payment, particularly in a redundancy situation. The only way to avoid a challenge, and HMRC has recognised this by providing guidance on this point, is to show that paying in lieu is not an automatic response. So the company would have to ensure that there is no long-term expectation or custom of receiving a PILON instead of working partial or all of the notice period. Instead, there must be a genuine assessment procedure in place for making a PILON. In practice, that means employers that make PILONs instead of giving notice must assess the circumstances of each employee’s termination, under an internal written procedure.
So is it safe for employees to accept notice paid in this way, when they are effectively indemnifying the company against any excess tax charges? Unfortunately, this depends on whether there is a genuine assessment procedure for each compensatory payment paid which includes a notice payment.
There is always a risk that the Inland Revenue will carry out a spot check and find that paying in lieu of notice was an automatic response.
If the employer is unwilling to remove the tax indemnity, it is the employee’s choice whether to take the risk of paying further tax at a later date, rather than having their notice treated as taxable by their employer.
In the Settlement Agreements we sign off for employees, we always make sure that any indemnity clauses obligates the employer to provide their employee with the opportunity to challenge any demands for excess tax. This is because HMRC will firstly go back to the employer to demand any excess tax. The employee will then have to pay this excess tax payment back to the employer.
From an employee’s perspective, the worst-case scenario would be having to pay back this tax to the employer because they have provided an indemnity, even if this excess has been wrongly requested and paid by the employer.
If you are an employer, find answers to other frequently asked tax queries in our free Factsheet on Settlement Agreement payments for Employers.
If you have any queries about accepting or offering a Settlement Agreement to an employee, please contact one of our Settlement Agreement solicitors either by calling 01273 609911 or via email to Fiona Martin, our head of Employment.