Up to £30,000 and more Will yours be tax-free? Those were the days! In recent years, the Revenue has made life much more complex. Many handshakes which would have escaped tax in the past are now caught. Nonetheless, with planning, it is still possible as often as not to avoid tax on payments up to £30,000. In this article, we shall explain how. And we shall also suggest, for those who do find that some tax is payable – either because they are caught in the Revenue’s new stricter rules, or because their handshake exceeds £30,000 – how they might minimise their contribution to government funds. In fact, our article is in two parts. That’s because the issue of pay in lieu of notice has become so tortuous that it’s almost worthy of a tome on its own!
As will be seen, both segments of the article are influenced by recent rulings in tax disputes. The subject of termination payments remains as contentious as ever!
We start at the gentle end of the scale – with something which, as often as not, the Revenue almost without question accept can be received tax-free. Often, but not always.
Essential tips for redundancy payment negotiations
If you are made redundant you may be able to receive tax-free a much greater sum than something equivalent to pay for your notice period. This is so, even if your employer agrees to pay much more than the statutory minimum redundancy pay. However, in such cases, the Revenue will want to be certain that the payment does not, in reality, include earnings “dressed up” as redundancy pay. There must not be included, for example, what is really l a terminal bonus, or l a payment for reaching production targets in the run-up to redundancy, or l a payment which is conditional on doing extra work following the issue of the redundancy notice. It is important, therefore, that your redundancy arrangements are correctly worded to avoid these traps. Perhaps, to be on the safe side, you could ask your employer to take advantage of the Revenue clearance procedure here (if he hasn’t already done so): quote the reference SP1/94 to him. Remember, when it comes to a termination payment, it is not normally possible to obtain official approval of its tax-free status: redundancy cheques are a notable exception to this. So far then, nothing too problematical. But now things are going to change.
The golden handshakes the Revenue don’t like
The kind of termination payment which, in practice, most often causes major problems with the Revenue is neither:
– a redundancy payment (it is often indisputable that the employee is redundant and, in any event, an advance clearance procedure is available), nor even
– a payment in lieu of notice (as such payments are generally quite modest in size).
No, it is the ex gratia payment which is made, perhaps, to a long-serving employee or director who leaves voluntarily; or to someone who, although not redundant, is eased out for other reasons. Can payments which are genuinely made in these circumstances be received tax-free, provided that the £30,000 ceiling is not breached?
The 2 Revenue traps to get through
As indicated at the beginning of this article, the usual answer to this question used to be a straightforward: yes. But not any more. In recent times, the Revenue have come up with two additional hurdles in an attempt to tax a greater number of golden handshake payments. It is now necessary to consider:
- Is the payment caught by the “restrictive covenant” rule?
- Or by the “retirement” rule? We look at each of these two potential hazards in turn. And, of course, suggest what might often be done to circumnavigate them.
1. The restrictive covenant trap and how to avoid it
We look at this aspect first, as it is the less complex of the two. Quite simply, the tax statutes contain a special rule headed “Payments for restrictive undertakings”. This rule is designed to tax payments such as those which might be made to an employee restricting his freedom to compete with his (former) employer after he has left. The Revenue have let it be known that if, as part of the financial settlement relating to the termination of employment, such an undertaking is given, they will tax the otherwise tax-free handshake payment in full. They have confirmed, however, that if a restriction of this sort “formed part of the terms on which the employment was taken up” then they will not pursue the restrictive covenant argument, even if the undertaking is reaffirmed in the paperwork supporting the termination payment. Here, then, is what to do.
- If you have agreed with your (former) employer to restrict your future activities to some degree, resist any attempt your local inspector might make to tax your golden handshake under the “restrictive covenant” rule if the undertaking was given in your original employment contract. The reference to quote the inspector here is SP3/96.
- If, on the other hand, the undertaking is a new one, then you could be caught. Are you really obliged to give the undertaking? If so, could there perhaps be two payments, each with its own documentation: one for the restrictive covenant (taxable) and the other for the ex gratia termination payment (which should be tax-free)? That’s the “easy” hurdle. Now for the more difficult one.
2. The retirement “arrangements” trap
A lump sum termination payment will attract income tax on the full amount, even when the payment does not exceed £30,000, in the following circumstances l where it is made in connection with the employee’s retirement (or where it is made to his family in connection with his death), and l it involves some kind of “arrangement” to make such a payment. This, the Revenue say, is a retirement benefits scheme, and a payment under such a scheme is taxable. The use of the word “arrangement” here seems deliberately vague. But the Revenue have given some clarification of what they mean by this. They say it includes “any prior formal or informal understanding with the employee”.
Furthermore, the term in this context includes “any system, plan, pattern or policy connected with the payment of a gratuity”. In short, the Revenue are determined to catch large numbers of golden handshakes in this way, as only a few such payments will be made without even an informal understanding beforehand.
We should add here that, very recently, a challenge was launched against the Revenue’s interpretation of the law. Unfortunately, the Revenue largely won. The only crumb of comfort was that one aspect was not accepted: their view that a simple decision at a meeting to make an ex gratia payment in itself constituted a “retirement benefits scheme” was rejected. But, by and large, their views remain intact. In practice then, what sorts of handshake are likely to be taxed under the above rule – the “retirement” rule – and what are more likely to escape? We give below a distillation of views, which we have derived from the Revenue’s comments. If you can, get yourself within Category S!
At a glance checklist for planning the retirement rule
Is the handshake taxable under the “retirement” rule?
Key: S = Safe V = Vulnerable U = Unsafe
- If recipient is under age 50, and is moving to another job S
- If recipient is not taking another job, and is close to normal retirement age for his present job V
- If payment is for genuine redundancy or loss of office S
- If recipient is 60 or more, and is not moving to another job U
- If recipient is in his early 50s, and moves to a new job as part of his normal working career S
- If recipient is in his late 50s, but takes another job V
- If recipient is in his 50s and, for reasons of health, he changes to a less stressful job and the “ex gratia payment made is purely consolation for the loss of health which results in premature termination of employment” S
Note, in particular, point 7. Clearly there is scope here for paying a tax-exempt golden handshake when it is possible to plead “medical grounds”.
The 2 exceptions to the rule
Finally, even if you do seem to be caught by what we have just said, you may yet escape. There are two letouts, and if either of these apply to you, your handshake will be of the tax-free variety:
- If the payment is made solely because of your disablement (or death) by accident, whether or not the accident occurs in the workplace; or
- If no other lump sum is potentially payable to you, in respect of your job, upon your retirement. Of course, these let-outs will not be available to the majority of employees.
Note in particular that an employee who belongs to a company pension scheme, under the terms of which a lump sum is normally payable on retirement if he so chooses, is ineligible for let-out 2. And it makes no difference whether the employee actually elects to take a lump sum from the pension fund: the fact that he has the option to do so is sufficient to deny him a tax-exempt handshake!
In view of this, should employees perhaps consider not being in company pension schemes, taking out personal pensions instead? It seems clear that a lump sum paid under the commutation provisions of a personal pension scheme is not caught, so that let-out 2 can apply. And the same goes too for lump sums which become receivable upon retirement under an endowment policy. With that thought, we bring this part of the article to a close.
The retirement trap: a final thought
The tax rules concerning lump sum termination payments are complex, containing their fair share of borderline anomalies and wrinkles. For example, here’s one which we did not highlight earlier, but which readers may have spotted from what we have said already. l Did you notice that, should you die otherwise than in an accident, and an ex gratia payment is made, this could be taxed under the “retirement” rule )? l But if you’re only ill, you can escape? It’s clear which is the better way to terminate your employment!
Get the documentation right...
We now move on to something more mundane: paperwork! But don’t be put off. It may sound uninteresting, but it’s just as important as everything else we have mentioned!
So far, we have assumed that ex gratia payments made on the termination of employment are tax-free, subject only to the rules of taxing restrictive covenants and retirement payments – and, of course, the well-established rules for taxing payments in excess of £30,000. But this is a dangerous assumption to make. Occasionally termination payments are taxable in full – even though they are not made on retirement or in return for a restrictive covenant. In brief, if the Revenue can show that the termination payment is a reward for services provided, then they’ll tax it. It is vital, therefore, that the documentation shows that the payment is not made in return for services.
The board minute or letter, evidencing the payment, should be carefully worded. Very often, the handshake will indeed be a payment for not providing services, namely compensation for leaving the job early at the request of the employer. Such a payment might be made, for example, in return for the abandonment of the benefits of a service agreement upon its early termination by the employer: the payment should be described in the documentation as “compensation for loss of office”.
Alternatively, the payment could be a pure leaving present: a payment of a sum which the executive could not secure in some form or another through legal channels. Ensure it is clear from the documentation that the payment is not an extra reward for past services (or for future services). For example, the payment might be made to a departing executive as “a gift in recognition of his personal qualities”.
and avoid this clause!
Finally, an early warning to those about to enter into service agreements. Avoid golden handshake clauses. A Court ruling, given in 1981, established that if a service agreement (or contract of employment) includes a clause to the effect that a compensation payment will be made if the agreement is terminated early, then any such payment is taxable. That is because, in such an event, the payment is not made for abandoning the service agreement. Quite the opposite: it is made in accordance with the specific terms of the service agreement.
Hence it is normally far better to make no mention of an ex gratia payment. After all, should the employer terminate the agreement early, the executive will be entitled to some compensation (under general law) in any event.
Let us now move on to the last segment of our article. If the ex gratia payment is caught by the tax rules fair and square (well, square at least), what can be done to minimise the liability? Similarly, even if the handshake does qualify for the £30,000 exemption, what about payments which are greater than this: how might the tax on the excess be kept to a minimum?
If you are taxed, here’s what you can do about it
If a golden handshake payment is to be made and, for whatever reason, some income tax will become payable, consider the following: l It is often advisable to avoid, if possible, a termination of the employment towards the end of a tax year. The departing executive may well have received a high level of income from his employment in that year. Are his prospects for the following tax year less rosy, as a result of him losing his job? If so, a termination at the beginning of the new tax year may be preferable. The objective, clearly, is to ensure that (so far as possible) he pays income tax on the handshake at basic rate only (22%) rather than at the higher rate of 40%.
As a follow-on to the above point, if a low level of income (and capital gains) will not arise naturally in the year of termination, try making a conscious effort to minimise it. And/or try to maximise personal reliefs and allowances. More personal pension premiums, perhaps?
If some tax will be payable at 40%, arrange for the termination payment to be made after the employment has ceased: in that way, only basic rate tax need be deducted by the (former) employer. The additional 18% of higher rate tax will have to be paid by the executive direct, as part of his self-assessment many months after the end of the tax year.
On an entirely different tack, could perhaps part of the payment be made, not to the departing executive himself, but to an approved pension scheme for his benefit (within the tax approval limits)? Such a contribution would not be taxable upon the executive.
Summary
Not surprisingly, golden handshakes and the Revenue do not mix very well. If a tax inspector spots half an opportunity to take the shine off a handshake payment, he’ll gladly do it. So don’t give him the opportunity!
A quick guide to a taxfree golden handshake Up to £30,000
If you are about receive a lump sum on the termination of your employment, and you don’t want to pay tax on it (or at least, not on the first £30,000!) follow these guidelines if you can.
- The payment must not be a reward for services. The documentation should describe the reason for making the payment – such as compensation for loss of office; or an unsolicited gift, following your long association with the company, in recognition of your personal qualities.
- Ensure the handshake documentation contains no reference to a restriction on your future activities – unless all this does is to confirm a term of your original employment contract.
- Subject to 4 below, the payment must not be made on retirement (or in anticipation of retirement). Could you take another job, or become selfemployed? Study our synopsis on page 3 and aim for category S or, at the very least, V.
- If the payment is made at or around your retirement age, is the timing here just coincidental? Are you sure it’s not a redundancy payment? Even if it isn’t, perhaps it could be exempt if you are not a member of a company pension scheme. Maybe you (or to be more accurate, your employer) could get advance approval from the Revenue. And if you can’t squeeze yourself into these guidelines (or if you’re lucky enough to be in line for more than £30,000), try to minimise the tax bill. Could you, for example, engineer matters so that your golden handshake becomes receivable in an otherwise “low tax year”?
Remember however, that even when the payment is made on retirement (and you appear to be caught by 4), the Revenue cannot tax you unless the payment is made under some prior “arrangement”. If only you could plan a spontaneous handshake!
£30,000 limit overdue for a rise
The original tax-exempt ceiling for golden handshakes was £5,000. It was increased to £10,000 in 1978, to £25,000 in 1981 and to £30,000 in 1988. Why nothing for the past 18 years? Clearly, the machine is in need of a good oiling.
Alan Rook is a chartered accountant and has been writing on tax matters for the past 15 years.
P.S. If you enjoyed this article then we encourage you to sign up for the free Fleet Street Daily eletter. Learn what you can expect from today's markets -- and how to prosper in the face of uncertainty. You won't find more thought provoking writing anywhere on the Internet.