When an employee stops working for you and you pay them off, tricky tax and NI rules apply. These can, for example, result in extra NI bills where employment contracts are worded badly. What are the main points to watch for?
Earnings or something else?
The tax and NI payable on most types of payment to employees depend on whether or not they count as earnings. While it sounds logical that all payments to an employee automatically fall under this heading, that’s not the case. Some, mainly those relating to the termination of employment, are taxed differently.
When a lump sum is paid on termination of employment, e.g. in the event of redundancy, HMRC frequently tries to assert that the payment is earnings. That’s bad for employers because NI at 13.8% is payable on earnings. But this can be avoided entirely by successfully arguing that the payment relates to the termination of the job and doesn’t arise from the terms of employment.
Where a clause in the employment contract gives the employee the right to a payment if their job is terminated, you will have fallen straight into HMRC’s trap because contractual pay always counts as earnings. A common example of this type of clause is one that allows you to pay off an employee instead of requiring them to work a notice period. Contractural payments in lieu of notice (PILONs) are liable to both PAYE tax and NI.
Tip. Unless it’s vital to your business, we recommend removing PILON clauses from employees’ contracts, where appropriate. While you might want to retain them for senior staff, we see no point in them for junior employees.
Tax and non-contractual payments
However, dodging the contractual payment trap for PILONs won’t prevent a charge. Special rules require employers to deduct tax from termination and other lump sum payments if they aren’t liable to be taxed as earnings (see The next step ). But, as you probably know, the rules allow the first £30,000 tax free, meaning only the excess is taxable through PAYE.
NI and non-contractual payments
The NI treatment of termination payments differs from that for tax. In this case there’s no special rule for charging NI. Therefore, as long as the payment isn’t classified as earnings, no employees’ and employers’ NI is payable, regardless of how much you pay.
For example, if you pay off a senior employee or director with a £70,000 termination payment, £40,000 of this will be taxable, but none of it will be chargeable to employees’ or employers’ NI.
Tip. To remove doubt over the status of a termination payment, HMRC offers an advance clearance service (see The next step ).
Our advice is to decide how you think the payment(s) should be treated before contacting HMRC. It’s more likely to agree that a payment doesn’t count as earnings if you put forward a good case at the outset rather than leaving it up for debate.