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Commercial Angles' Newsletter - March 2002

Termination payments

Section 148 of the Income and Corporation Taxes Act 1988 provides that any payment in excess of £30,000 made in connection with the termination of a person's employment is taxable on the recipient. The tax exemption on the first £30,000 only applies if the payment can not be taxed under some other rule. Termination payments made under a contract of employment, for example, have always been taxable in full under section 19 of the act. It is only when there has been a breach of contract or where the payment is clearly ex gratia that the exemption may apply. The Inland Revenue have always been keen on limiting the exemption and a recent High Court decision in the case of Richardson v Delaney may help them limit it further.

Richardson v Delaney

Delaney's contract of employment allowed for termination by the employer giving eighteen months' notice or making a payment in lieu of notice. The employer gave Delaney notice in writing that his contract was to be terminated at some future unspecified date and instructed him to take "garden leave" on full salary and benefits. The same day, the employer wrote a letter to Delaney, without prejudice, stating that his employment would end on 28 December 1995. Subsequently Delaney and the employer agreed the severance package, which was in excess of £30,000.

The general commissioners for taxes held that the first £30,000 was exempt from income tax but the tax inspector appealed to the High Court. The inspector argued that the termination payment was taxable in full under section 19. The High Court agreed. It held that the employer had acted in accordance with the contract of employment by giving written notice. Although the severance package was not exactly like that included in the contract, the difference was not substantial. There had been no breach of contract and the termination payment had arisen from a contract of employment. The payment was taxable under section 19.

Potential impact on employers

Being able to make part of an employee's termination payment exempt from tax is often a key component in a discussion with a departing employee. The Richardson v Delaney case highlights the danger of negotiating a termination package with an employee before the contract has actually been terminated. To prevent similar situations, there are things an employer can:

Ensure that there is a breach of contract.
Ensure that the contract of employment does not entitle the employee to pay in lieu of notice. If pay in lieu is mentioned in the contract then its payment may be taxable on the employee. If the majority of the termination package is such pay in lieu then the employer may have a problem. An employer is only permitted to make payments free of tax when it is clear that the payment is in respect of damages for breach of contract or ex gratia.
In the case of uncertainty, the employer may give details of the circumstances to the Inland Revenue and ask them to give a pre-clearance in writing, stating whether they believe part of the proposed payment to be exempt from tax.
Include a tax indemnity as part of the terms of the termination package.

Articles from previous newsletters