Page last updated at 23:39 GMT, Wednesday, 15 October 2008 00:39 UK

The tax pitfalls of redundancy

Money Talk
John Chaplin
Director of employment taxes, KPMG UK

At a time when many businesses are simply focusing on survival, some may have to face the prospect that the only way to continue in business is to 'let people go'.

John Chaplin, KPMG
John Chaplin points out the potential pitfalls for employers

That in itself can be a difficult decision, but how do employers cope with the seemingly ever more complicated income tax rules surrounding redundancy payments?

The very fact that a business is in the unfortunate position of reducing head count means that they will want to make the pay-off attractive to workers in order to make the changes as quickly and painlessly as possible.

However, the cost to the business also needs to be minimised and one obvious 'saving' is to minimise the amount of tax paid by the employee and the National Insurance Contributions (NIC) paid by both the employee and the employer.

Statutory Redundancy Payment

Certain payments can be tax and NIC-free without too much concern.

For example, a statutory redundancy payment is not subject to tax and NIC.

This can be up to 330 per year of service, up to a maximum of 20 years and then multiplied by up to 1.5 depending on the worker's age, giving a maximum statutory redundancy figure of 9,900.

Additional 'termination payments'

In many cases employers will either wish, or be under pressure, to make payments in addition to statutory payments and this is where problems can arise.

Unsuspecting employers could be positioning themselves for a substantial bill in the coming months

The tax and NIC status of these extra payments can differ depending on the wording of the contract of employment, staff handbooks, union agreements and even local custom and practice.

The tax legislation contains a statutory 30,000 exemption relating to certain termination payments (potentially more where foreign service is involved).

And the NIC rules contain a similar exemption - this time without any cap on the amount that can be paid free of NIC.

Many employers believe that these exemptions apply regardless of the circumstances and this is what can interest the taxman.

In many instances unsuspecting employers could be positioning themselves for a substantial bill in the coming months and years as it is all too easy to fall foul of the rules which are being interpreted increasingly strictly by Her Majesty's Revenue & Customs (HMRC).

How it can go wrong

If we take the example of a worker who is a higher rate taxpayer and who receives a 10,000 payment in addition to any statutory redundancy entitlement, the worker could receive as little as 5,900 after tax/NIC whilst the employer could have to pay up to 1,280 in employer's NIC if the payment is not structured correctly.

In the above example, the worker will only receive slightly more than half of the total cost to the employer and so the employer may be faced with either increasing the amount paid or risk the wrath of the taxman.

Even worse is that an unsuspecting employer might pay the 10,000 - not realising that they could also face a tax/NIC bill of 5,380.

If several redundancies are involved the numbers can really add up.

With unemployment forecast to rise sharply in the coming months, it is safe to assume that HMRC's risk assessment teams are looking out for potential "high risk" employers.

In the event that the employer has not paid the correct PAYE/NIC, HMRC will pursue these liabilities (plus penalties and interest) and the bill can come out of the blue, sometimes several years after the event when the managers involved may themselves have left and the paperwork long-consigned to the archives.

So, what can an employer do?

Employers can help to maximise the payments that employees receive and reduce the cost of providing those payments by checking that they meet the criteria set down in the legislation.

Some simple steps to consider include:

  • Understanding what you may be expected to pay before it becomes necessary including establishing what employment contracts, staff handbooks etc say
  • Establishing whether any local custom and practice has been established as a result of previous redundancies etc
  • Seeking tax advice before engaging in employee discussions both to understand the initial position but also to discuss any methods of mitigating the tax/NIC due
  • Considering formal HMRC clearance for redundancy schemes at an early stage
  • Taking care around communications with employees, unions and even press releases

I can't promise that these steps will always reduce the tax bill but they should at least help to avoid the shock of an unexpected one arising in the future.

The opinions expressed are those of the author and are not held by the BBC unless specifically stated.

The material is for general information only and does not constitute investment, tax, legal or other form of advice.

You should not rely on this information to make (or refrain from making) any decisions.

Always obtain independent, professional advice for your own particular situation.

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