First the sack then the tax

The Inland Revenue seeks to claim a slice of the redundancy payments made by employers. Ian Hunter reports

UNTIL recently, one of the few crumbs of comfort available on being dismissed was the knowledge that any termination payment was likely to be free of tax. However, recent indications from the Inland Revenue have cast some doubts as to whether this will continue to be the case.

Until the Revenue's position becomes clear, there is an increased likelihood that cautious employers will deduct tax at source from payments made to employees on the termination of their employment. This is to avoid being pressed subsequently by the Revenue for tax that should have been deducted.

On dismissal, employees have two potential claims, one contractual and the other statutory. The starting-point for calculating contractual damages is the value of net salary and other fringe benefits (such as pension contributions or the use of a car) that the employee should have received during the notice period. Employees who have completed over two years' continuous employment with an employer have the right not to be unfairly dismissed.

A recent case in the Court of Appeal has cast doubt on whether this two- year qualifying period is justifiable, and the matter has been referred to the House of Lords. The outcome may be that all employees, regardless of length of service, will acquire the right not to be unfairly dismissed.

Statutory awards for unfair dismissal are made up of two parts. First there is the basic award, which is a sum equal to between pounds 102.50 and pounds 307.50 for each completed year of employment, depending on age. The second tier, the compensatory award, is subject to a maximum of pounds 11,000. Both awards are set to increase in the autumn, subject to parliamentary approval.

In most circumstances, employers have, until now, been relaxed about paying up to the first pounds 30,000 of any termination payment to the employee free of tax, regardless of whether the payment flows from a contractual or statutory claim or a combination of both.

Any sum in excess of the first pounds 30,000, subject the prior issue of a P45 form, is taxed at the basic rate. The employee is then expected to account in his or her annual tax return for any excess tax owing .

The taxation of termination payments is governed by Section 148 of the Taxes Act 1988. Several Inland Revenue district offices have started to challenge the tax-free element of these payments in cases where the employee confirms that the payment is accepted in return for a waiver of all claims.

If this reasoning becomes accepted practice, the impact on dismissed employees could be wide-reaching. It is normal in most dismissal situations for an employer to ask for a waiver to preclude the employee from subsequently attempting to sue.

It has been argued by the Inland Revenue on occasion that the giving of a waiver is in reality a restriction, and that payments made in return for comp- lying with a restriction should be taxed under Section 313 of the Taxes Act rather than Section 148. Section 313, unlike Section 148, does not provide for the first pounds 30,000 to be paid free of tax.

Richard Monkcom, a partner and tax employment specialist with the City law firm Druces & Attlee, comments: "The recent change in practice by the Inland Revenue, although not yet universal or consistently applied, appears misguided. Section 313 was enacted in the 1950 Finance Act specifically to reverse a decision involving a restrictive covenant preventing a director from competing against a former employee after termination of his services. In my view, it was not intended to catch a situation where an employee is paid compensation on the termination of his employment and the employer at the same time requests a waiver against any potential claims the employee may have been entitled to pursue."

An Inland Revenue spokeswoman confirmed that a review was being undertaken on the guidelines regarding applicability of Section 313 that are given to tax inspectors. A statement was not expected before the end of the year.

Mr Monkcom says: "The problem is that in the interim, employers are likely to adopt a cautious approach. They may decide to deduct tax at source and leave the employee to argue the case with the Inland Revenue. In other cases, they may seek Inland Revenue clearance before payment is made."

However, one approach increasingly being adopted by employers is to expressly attribute a small payment to the giving of the waiver by the employee. This payment is taxed in accordance with Section 313, thereby allowing the remainder to be paid free of tax.

The Inland Revenue is also likely to investigate closely payments made to dismissed employees nearing retirement. If the Revenue takes the view that the payment does not relate to the termination of employment but is in reality a retirement payment, it will seek to tax the sum paid in full.

Until the Inland Revenue clarifies the position, fears will remain that some golden hand- shakes may end up looking distinctly tarnished.