Compromise agreements

Under the provisions of the Employment Rights Act 1996, it is unlawful to make any agreement that is intended to limit an employee's rights under the Act or to prevent an employee making a claim to an employment tribunal. However, those restrictions can be avoided if a "compromise agreement" is reached between employee and employer in conjunction with an ACAS conciliation officer.

When a compromise agreement is reached in connection with termination of employment, the employee agrees not to start any legal proceedings against the employer in return for a payment. Such an agreement is a restrictive covenant, as it restricts the conduct or activities of the employee after termination. Financial settlements in respect of restrictive covenants give rise to a charge to income tax and NICs.

A compromise agreement, however, is exempted from tax and NICs by the provisions of the Inland Revenue's Statement of Practice 3/96. Payments made to the employee in connection with the agreement are liable to tax only to the extent that, together with other non-contractual termination payments, they do not exceed £30,000.

The basis for the exemption is that payments made in respect of compromise agreements are normally made to settle any claims that the employee may otherwise have against the employer due to the termination of employment. As a result, none of the payment is attributable to the restrictive covenant.

However, most compromise agreements include a "repayment clause", whereby the settlement sum has to be repaid if the employee decides to ignore the compromise agreement and start litigation. It has been argued that, because the settlement sum is lost if the employee starts litigation, the payment must, at least in part, be attributable to the restrictive covenant.

Responding to this argument, the Inland Revenue states that, following legal advice, a tax charge on compromise agreements would arise only in exceptional circumstances. Where it can be shown that the compromise agreement deals with genuine claims and the payment properly reflects the value of those claims, the settlement sum is fully attributable to the termination. The Revenue would only query the nature of the compromise agreement if the amount of the settlement is clearly in excess of a reasonable sum for settlement of the claims.
(Source: www.inlandrevenue.gov.uk/bulletins/tb67.pdf )
...back to 17 October 2003

Payment and benefits paid on change of employment

Section 401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) (formerly s.148 of the Income and Corporation Taxes Act 1988 (ICTA) defines the tax liabilities that arise when an employer is given a payment or a benefit in respect of two specific situations:

• termination of employment, or
• a change to the duties or earnings of the employment.

This is the section that limits the tax liability to the extent that the value of the payment or benefit exceeds £30,000. The section of the Act only applies only if other tax provisions do not take priority, e.g. a general liability to tax on a payment or benefit that stems from the employment rather than from the termination or change of employment.

The Inland Revenue, during the rewriting of the ITEPA, received legal advice that the guidance that it had previously given on these priorities was incorrect in the context of payments and benefits provided in the second of the above situations, i.e. where a payment is made or a benefit provided to compensate for a change in the employee's duties or earnings, commonly for a demotion or reduction in pay.

To illustrate the change, if an employer makes a payment or provides a benefit in respect of the first of the above situations, i.e. termination of employment, the priorities are:

1. if the payment or benefit derives from the employment, normally because it is contractual, it is taxable in full, but
2. if it derives from the termination, normally because it is not contractual, it is taxable to the extent that it exceeds £30,000.

However, if an employer makes a payment or provides a benefit in the second of the above situation because, for example, an employee's salary is being reduced, the priorities applied by the Revenue were:

1. if a payment is made that derives from the employment, it is taxable in full
2. if the payment or benefit derives from the change of employment, it is taxable to the extent that it exceeds £30,000.

In effect, there was a presumption that a benefit provided because of a change in employment benefited from the £30,000 exemption.

The Revenue's new advice sets the following priorities:

1. if a payment is made that derives from the employment, it is taxable in full
2. if a benefit is provided that derives from the employment, it is taxable in full
3. if the payment or benefit derives from the change of employment, it is taxable to the extent that it exceeds £30,000.

The effect of the change is that, if a benefit is provided because of a change in the employment, the employer must first decide if, in reality, it derives from the employment, i.e. because there is a contractual entitlement to the benefit is the particular circumstances. If so, the benefit is taxable in full. If it does not derive from the employment but is a benefit provided solely to recognise the change in the employee's terms and conditions, then it benefits from the £30,000 exemption.
(Source: www.inlandrevenue.gov.uk/bulletins/tb65.pdf )
...back to 27 June 2003

Pay in Lieu of Notice

The Inland Revenue has announced changes to its approach to certain aspects of the tax liabilities that arise when employees are paid in lieu of notice when their employment is terminated. In simple terms, pay in lieu of notice is taxable in full if it is a contractual provision, but taxable to the extent that, together with other termination payments, it exceeds £30,000 if it is not contractual. In practice, however, it is not always easy to determine whether or not a payment is contractual and a number of situations where the Revenue has decided to take a different view are discussed at length in Tax Bulletin 63. The document may be downloaded from www.inlandrevenue.gov.uk/bulletins/tb63.pdf .

Discretionary payments

Since 1996, the view has been that, where the contract gives the employer discretion as to whether to make a payment in lieu of notice, the payment, if made, is taxable in full as the contract has been terminated under terms defined in the contract. Although there is no change to that interpretation, developments since 1996 have clarified the position of payments of damages that are made because the employer fails to give contractual or statutory notice when terminating the employment.

If the contract provides that payment in lieu of notice is discretionary, the employer may choose not to give notice of termination but to make instead a payment of damages in respect of that breach of contract. Such a payment is likely to be less than a payment in lieu of notice would otherwise have been because the employer is entitled to lessen the sum due as damages by the extent to which the employee mitigates the loss, for example, by obtaining new employment during what would have been the notice period.

Consequently, the Revenue holds that, if a payment of damages is substantially the same in value as the payment that would have been made if the employer had exercised the contractual discretion, that payment is treated as having been made under the terms of the contractual provision and, thereby, taxable in full.

A genuine payment of damages is likely, therefore, to be lower than would otherwise have been the case, as a result of the employee mitigating the loss and the employer taking into consideration the lower tax and NICs liabilities that apply to a payment of damages. In addition, it would be advisable for the employer to inform the employee in a letter of the decision, in exercise of the discretion, not to pay in lieu of notice.

Implied contractual terms

The view since 1996 has also been that, if an employer regularly pays in lieu of notice even though there is no express contractual entitlement, a contractual entitlement is implied. As a result, the payment is viewed as being contractual and subject to income tax in full.

The Revenue is now of the view that this position cannot be justified. A contractual term cannot be implied if the contract expressly states something to the contrary. Therefore, as all employment contracts specifically require employers to give notice when terminating the contract, it cannot also be held that there is an implied term that the employer may make a payment in lieu of notice.

Therefore, simply because an employer normally pays in lieu of notice, it does not automatically mean that the payments are contractual and, as a result, taxable in full. However…

Automatic payments in lieu of notice

The fact that a payment in not contractual does not, in itself, mean that it does not fall within the definition of "emoluments". Emoluments arising from the employment are taxable in full. Some non-contractual payments, such as tips and discretionary bonuses, are nevertheless emoluments. Therefore, if the employment contract says nothing about payment in lieu of notice, it does not follow that such a payment does not constitute "emoluments".

For example, if an employer always pays in lieu of notice when employees are redundant, the payments, although non-contractual, are an integral part of the employer-employee relationship and have their source solely in that relationship. The payments are emoluments and are liable for tax in full. Automatic payments suggest that the employer has not considered, in each particular case, whether to pay in lieu of notice or to act in breach of contract and pay damages for that breach.

In all of these situations, the Revenue is clear that every case must be considered on its merits. In particular, the Revenue will consider whether or not the payment has the characteristics of a payment of damages. Employers should not, therefore, rely on the argument that a payment in lieu of notice was non-contractual. It would be better to be prepared to demonstrate that there really was a breach of contract and that the payment is a payment of damages.
Payroll Briefing 17 - 6 March 2002

Termination Payments

The complex statutory provisions for the taxation of termination payments are set out in section 148 of the Income and Corporation Taxes Act 1988. As described in the latest issue of Employer's Bulletin, the Revenue has issued new guidance to tax inspectors in response to reports from employers and accountants that Revenue offices are inconsistent in their application of the rules. All of the Revenue's internal guidance manuals are available on the Revenue's website and this new information on the handling of termination payments may be found in the Schedule E manual, at www.inlandrevenue.gov.uk/manuals/senew/se12800.htm
Payroll Briefing 1 - 11 June 2002