Payments in lieu of notice – Are they taxable?

A payment in lieu of notice often gives the Employer a headache. Should it be taxed as part of employment income or does it fall within the £30,000 exemption for termination payments.

The problem was highlighted recently in a case (S Manley TC2517). In this case the employee received payments from his employer in respect of his employment being terminated. Employer and employee came to a compromise agreement whereby the employee received a payment of £38,522 in lieu of notice which was subject to tax and national insurance. He also received another payment of the same amount described as an “ex gratia” payment which was also subjected to tax and national insurance.

When the employee submitted his tax return he claimed that the first £30,000 of the payments he received should be tax-free on the basis he had been made redundant, HMRC disagreed, arguing that the payments were in lieu of notice and he had been contractually entitled to them and were therefore taxable.

The Contract of Employment provided that after a probationary period of 4 weeks, the employee’s appointment would be subject to a minimum notice period by either himself or his Employer of 26 weeks. It also stated that “once notice had been given by either side the company may in its sole and absolute discretion terminate the employment with immediate effect by making a payment in lieu of the notice period, equivalent to the basic salary due. Such payments will be subject to tax and national insurance contributions”

The Company terminated the employment with immediate effect so that the employee was entitled to the payment in lieu of notice for which his contract of employment provided. The eventual agreement between the two parties stated that the employee would receive £38,522 in lieu of 3 months notice, subject to tax and national insurance and a further sum of £38,522 in lieu of the remainder of his notice period, also subject to tax and national insurance.

The employee argued before the Tribunal  that the “compromise” agreement superseded his contract of employment, and since the payments made to him were effectively redundancy payments(none of the staff whose contracts were terminated at the same time had been replaced), he was entitled to have paid to him a tax free sum of £30,000.

The First Tier Tribunal said that the compromise agreement entered into had to be read in conjunction with his contract of employment. In addition the agreement also made it clear that the payments were taxable as did a Solicitor engaged by the  employee. It is clear that the payments were made to him under his contract of employment and as such were taxable.

It is hard to understand how the Tribunal could have reached any other conclusion. The employee was entitled to 26 weeks (or 6 months) pay in lieu of notice and this is exactly what was paid to him albeit in 2 separate amounts.

In order for payments in lieu of notice not to be taxable the Contract of Employment has to be broken. Any such payments made in accordance with a Contract will always be taxable, in the writer’s opinion. Such payments often give rise to confusion and many people think that tax should not be deducted. Care should always be taken and advice sought whenever you are considering termination payments.

Should you require any advice on this subject please contact Green & Co.

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