Where an employer makes payments to employees under the terms of their employment contract, such payments are subject to income tax under s.62 of the Income Tax (Earnings and Pensions) Act 2003.
The above payments, amongst other things, could relate to wages, holiday pay, bonus and commissions.
Section 401 of the 2003 Act
Under Section 401 of the 2003 Act there is an exemption on paying income tax on sums payable up to £30,000 when arising as a consequence of the termination of the employee’s employment contract. Such payments could relate to statutory, contractual and ex gratia redundancy payments and non-contractual ex gratia payments made payable as compensation for loss of employment ie not relating to payments due under the employee’s contract of employment that will be taxable.
First tier tribunal
There has been a recent decision of the First-tier Tribunal that serves as a useful reminder that not every payment made on termination of employment via a settlement will be treated as a compensation for loss of employment and tax free.
In this case, the employee in his contract of employment had an entitlement to a guaranteed bonus taxable as earnings. A condition of the payment was that the employee would forfeit his bonus if he was subject to disciplinary action or had been summarily dismissed before the payment date; in this case disciplinary action had been taken against the employee before the payment date.
The parties subsequently negotiated a settlement agreement (previously called a compromise agreement) whereby it was mutually agreed for the employee to receive the bonus payment, but was this payment taxable?
The First-tier Tribunal decided that although the employee would have forfeited his bonus if his employment had been terminated under the terms of his employment contract, the settlement suggested something different. In light of the settlement terms the employee had effectively regained his entitlement to the accrued bonus (which was lost when the disciplinary action was started) i.e. the payment retained its status as earnings and thus was taxable, despite it being paid in the context of a termination of employment via a settlement.
When drafting settlement agreements, it is thus important for employers to consider having employee indemnity provisions in place in favour of the employer should tax be payable by the employee on any payment made to the employee under a settlement.
The contents of this article is intended for general information purposes only and should you require any further guidance please contact the advise-line team on 01455 852028.
