Tax free payments when leaving employment
The position regarding settlement agreement tax free payments when leaving an employer is complex. Further complexities arise where shares are relinquished upon leaving employment. We review the documents and your position and plan your strategy.
Helping employees achieve the best outcome
Drawing on our experience of the areas employees frequently need help with, we have put together:
- Top 10 FAQs on settlement agreement tax free payments when leaving employment; and
- Guidance on dealing with share transfers and the tax arising on any gains.
Each year we review hundreds of settlement agreements for employees, senior executives and directors. We combine employment law and tax expertise. We are also able to advise on the corporate aspects attaching to share awards. Usually your legal costs are paid by your employer.
Guidance on how payments on leaving employment work
The risk is you will lose tax-relief if the settlement agreement is not structured appropriately. HMRC routinely review settlement agreement payments to collect more tax. Don’t rely on your employer’s settlement agreement. It may not be drafted in a way that is tax efficient for you.
To help you approach payments on leaving the employer, it helps to distinguish between:
- Income payments – potentially subject to income tax and national insurance contributions under PAYE unless tax exempt.
- Capital payments – potentially subject to capital gains tax unless within the exempt annual allowance.
Income payments: Top 12 frequently asked questions
Here are the most important questions to consider.
- Are there separately agreed or identifiable sums of compensation?
- If yes: we treat the separate sums separately for taxation purposes. This may reduce your overall tax burden.
- If no: if it is genuinely a lump-sum compromise for claims of different characters, then we treat the sum as one. The drafting is important.
- Does the sum have the character of remuneration?
- If yes: then it is taxable as earnings. So income tax and National Insurance Contributions (NICs) under PAYE apply. Salary, bonus and commission along with holiday pay are treated as remuneration and taxed as such.
- Is the sum payable in consideration of the employee agreeing to a revised or updated restrictive covenant?
- If yes: then it is taxable as earnings. So income tax and NICs under PAYE apply. If the employer simply re-states existing restrictions no tax charge arises upon the employee’s termination.
- Is the sum contractual Pay In Lieu of Notice i.e. a PILON?
- If yes:the sum is taxable as earnings under PAYE. There is no £30,000 tax-free slice. You do need to review the employment contract or the director’s service agreement to determine if it includes a PILON clause.
- Has the employer given you full notice of termination of employment?
- If yes: then the notice pay will be taxable under PAYE in the usual way and holiday pay will remain taxable under PAYE.
- If no and before 6 April 2018: the employer is treated as acting in breach of your employment contract. Your employer is liable for damages. The first £30,000 of a damages payment where notice should have been paid, but was not paid, is tax-free. Income tax and National Insurance Contributions apply to a damages payment in excess of £30,000. If, e.g. you receive a redundancy payment, then the redundancy payment is fully taxable as you have already used your £30,000 tax free slice.
- If no and on or after 6 April 2018: The position will change from 6 April 2018. Damages paid in lieu of notice will no longer qualify for tax free treatment. Any payments made for notice period will be subject to income tax and national insurance contributions. If you receive a redundancy payment, the first £30,000 is tax free as you will not have used your tax free entitlement.
- Is the sum genuine compensation for loss of employment?
- If yes: then the sum is not classed as earnings, and only taxable under PAYE for amounts exceeding £30,000.
- Does the sum have the character of compensation? e.g., damages for wrongful dismissal, basic award or compensatory award for unfair dismissal, compensation for discrimination including injury to feelings?
- If yes: then the sum is not classed as earnings.
- If discrimination: However, if the payment arises from termination of your employment, there are cases where some of the compensation payable as a result of discriminatory treatment is taxable. It depends on the circumstances.
- HMRC clearance: In complicated cases, before you receive payment, consider obtaining HMRC clearance on how the payment will be taxed.
- Is the sum a redundancy payment?
- If yes: then it is not taxable as earnings on payments up to £30,000 gross.
- Is the sum a contribution by the employer to a registered pension scheme or an employer-financed retirement benefit scheme?
- If yes: then the sum is generally payable free of income tax and NICs, subject to your pension allowance.
- Are you to continue to receive benefits in kind such as use of car, medical health care, etc?
- If yes: then the usual rules to taxation of benefits in kind will apply and you remain liable for reporting and paying any tax not already collected via your notice of coding.
- Is the sum related to loss of share rights?
- Cash payments for loss of share option rights: will be taxable under PAYE. For example, if you receive a payment because your EMI option has lapsed or you cease to qualify under other HMRC approved share schemes such as CSOP options then the cash payment is taxable. The payment can be included as part of the settlement agreement.
- Cash payments for shares: should not be dealt with in the settlement agreement. The reasons for this recommendation are discussed below.
- Have you received a compromise agreement?
- If yes: then the same rules apply to taxation of a compromise agreement as apply to taxation of a settlement agreement.
Collection of tax
Your employer is required to collect income tax and national insurance contributions at source under PAYE. This means that you will receive payment net of tax. Most employers will include in the settlement agreement a tax indemnity. Under a typical settlement agreement tax the employee or director agrees to reimburse the employer for any tax HMRC assess as due under PAYE.
Employers who do not operate PAYE properly are liable for interest and penalty charges. Employers may seek to pass responsibility onto the employee under the tax indemnity. The indemnity does require consideration.
There is no requirement to operate tax on the ex-gratia element within £30,000.
What if your settlement agreement is not well drafted?
If the settlement agreement does not set out separately the sums attributable to:
- Tax free payments, and
- The sums attributable to taxable payments;
HMRC may seek to assess the full settlement payment to income tax and NICs under PAYE. HMRC has the power to pursue the employee or the employer. We are seeing an increasing number of cases where HMRC have pursued the employee.
Capital payments: How to deal with shares held when leaving employment
Shares form a distinct contract to the employment contract. The general rule is that payments made to purchase or cancel shares are capital payments to which the much lower rates of capital gains tax (CGT) apply.
Therefore, payments for shares should not be mixed up with the settlement agreement. This is because, payments under a settlement agreement are taxed at the much higher rates of income tax and national insurance currently in force.
Establishing share rights
Most employers require shares held to be transferred on leaving employment. Often these rights are embedded in the company’s articles of association or shareholders’ agreement as compulsory transfer provisions. In larger companies the rights may be set out in the share plan rules or as part of the terms of an LTIP.
A review of the relevant documentation is needed to establish how much consideration will be paid to the departing employee or director if he is forced to transfer shares on leaving. In private companies there is often negotiation around the share value – this is a particular area of our expertise.
Minority shareholders in private companies
The calculation of the value attaching to shares held by minority shareholders in private companies can become particularly difficult. We often recommend that an independent valuation expert is appointed as a means for resolving disputes.
Payment of capital gains tax
The rate of capital gains tax payable on the profit made when shares are transferred or bought back varies depending upon the circumstances. The questions to ask are:
- Do you own more than 5% of the issued share capital?
- If yes:then you may be eligible to pay capital gains tax at 10% on the gain you make on sale of your shares. To qualify for the 10% rate of CGT you must be employed or a director at the time of sale. Therefore you should enter into your settlement agreement after the sale of your shares.
- If no:then your rate of capital gains tax will be higher. The maximum rate applicable is 20%.
- If rather than a sale of shares, the company buys back the shares and cancels them – similar rules apply.
- Have you made other taxable capital gains in the tax year?
- If no:then you will be able to set off your annual exemption to reduce your overall liability to capital gains tax.
- If yes:then you will need to consider whether the other gains in the year are sufficient to utilise your annual exemption from capital gains tax. To the extent unutilised some of the annual exemption to capital gains tax will be allowable against capital gains made on share sales.
- Are you married or in a civil partnership?
- If yes:then you may be able to reduce your capital gains tax liability by transferring some of your shares to your partner to utilise their personal annual exemption from capital gains tax.
- Can you split the gains between two or more tax years?
- If yes:then you may be able to take advantage of the annual exemption from capital gains over straddling tax years.
Timing of capital gains tax payments
Capital gains tax on share sales will be payable to HMRC by 31 January following the tax year in which your gain arose. For example, if you made the gain on 6 June 2018 then the capital gains tax is not payable until 31 January 2020. The capital gains tax payment date is therefore more relaxed than that applicable to collection of tax due under settlement agreements where deduction of income tax and national insurance contributions are at source.
Alex Kleanthous is a partner in the employment team. Alex can help you understand your settlement agreement and secure the most advantageous tax position on payments received upon leaving employment. We also review and advise on the transfer of shares and provide solutions to minimise liability. The advantage of the expertise is that we solve issues relating to employment rights and share rights under one roof.