Compromise Agreement Tax Implications – Minimizing Your Tax Liability

(Newswire.net — February, 16  2013) Milton Keynes, UK — Facing the prospect of losing one’s job is never a pleasant experience. The challenge, uncertainty and prospect of finding alternative work quickly can be a very disruptive, not to mention a nerve-racking.

With that said any compensation that one receives under a compromise agreement settlement needs to see you through your period of unemployment while you search for a new position. And with that being the case, it is important for you to understand the tax implication on compromise agreement settlements, as in certain situations you may have some flexibility to repackage your financial settlement in such way as to minimise potential exposure to tax. Which means that you get to keep more of that money just when you’ll be needing it most.

First, let us very quickly cover what a compromise agreement is

An employment compromise agreement is a legal document entered between the employer and employee, in which in exchange for an employee’s promise not to take any kind of legal action against the employer at the end of the employment, the employer agrees to pay the employee a compensation package.

Employment legislation in the UK is complex and the only way that an employer can really safely end a contract of employment without the fear of possible legal action for breach employment laws and regulations is to enter into a compromise agreement with the outgoing employee.

With this in mind HM Revenue and Customs understands that for the purpose of compromise agreements, when an employment contract comes to an end, an employee may have various potential employment claims. For example failure to pay all salary due at the end of the contract; not giving correct notice or pay in lieu of notice; failure to have regard to certain protection provided by the Employment Rights Act 1996, and so forth.

HMRC therefore does not generally treat payments under an employment compromise agreement as a payment ‘for work undertaken’ pursuant to the employment contract, which is taxable, but instead treats it as ‘compensation for loss of employment’.  In other words payments under a compromise agreement for loss of employment is classified as ‘damages’, or which is sometimes referred to as a “golden handshake” payment.

But HMRC is also clear that certain other payments that are often lumped together with compensation payments for loss of employment are taxable if they are payments of a contractual nature.

Finally Salary Payments and Other Contract Benefits

All payments that an employee normally receives or is contractually entitled to, up to the date of termination of employment is taxed in the normal way. These include such things as unpaid holiday leave, car allowance, contractual bonus payments and commission and all other payments received under the contract of employment.

Payment in Lieu of Notice (PILON)

Whether a PILON is chargeable for tax depends on whether the payments paid pursuant to the contract. If the employee’s contract of employment is silent on whether the employer can make a payment in lieu of notice, then HMRC will consider this payment as compensation for termination and not a contractual payment since it is not within the contract.

However, some care needs to be taken here since HMRC will consider PILONs taxable whether they can be seen as being made “automatically”, habitually or by practice or custom. In other words where the employer has a history of making a PILON payment even though the contract with the employee does not expressly provide for this.

Garden Leave

There is a fine distinction to be drawn here between garden leave and a PILON for tax treatment, since as we have seen above, certain PILONs may not attract tax.

With garden leave, an employee will typically be given the correct notice of termination but be told not to attend work during the period up to the date of termination of employment. The employee is given leave to “tend the garden” while still serving the remainder of his contract.

This is to be distinguished from a PILON payment, where the employer simply pays-off the employee in substitution of asking him or her to work their notice. In this situation, the employment is treated as at an end, with a PILON payment the payoff for the notice period that the employee is entitled to.

Redundancy Payment

HMRC has special provisions for the treatment of redundancy pay.

Both statutory and an employer’s own contractual redundancy scheme (if one exists) have a £30,000 exemption to tax. An employee may therefore receive up to £30,000 tax free excluding all contract payments received on termination of a contract of employment.

As the employee is treated as still employed up to the date of termination, all contractual payments received during this period is subject to income tax.

Compensation and ex-gratia (Non-Contractual) Payments

All payments made as compensation for loss of employment, which are not contractual in nature, are exempt from tax on the first £30,000.

For example, an employee dismissed with correct notice, will be entitled to receive final salary and all other contractual benefits subject to deduction of NI and income tax. Any additional payments that an employer provides on top, in compensation for loss of employment, will be treated as exempt from tax up to the £30,000 limit.

If on the other hand, an employer terminates a contract of employment, without notice, in breach of contract and perhaps in circumstances that may give rise to a potential claim for breach of employment laws and regulations, the entire sum offered by an employer as compensation for loss of office is potentially exempt from tax on the first £30,000.

If you have any questions on compromise agreement tax implications, require more advice or guidance on employment compromise agreements generally, contact Graham Cardona at Cardona & Co who will be more than happy to have a chat over the phone to answer your questions.

Alternatively, you can head over to the following website address at http://cardonaandco.co.uk/compromiseagreement for more more information on the most frequently asked questions on compromise agreements.