UK redundancy-related payments: Common areas of tax difficulty and risk

COVID-19 has already had a profound impact on many organisations and across a wide variety of sectors. As a consequence, it is inevitable that many organisations will be examining their current workforce populations, seeking to restructure their business operations for a post-COVID-19 world and some will be considering closing down parts of their business operations altogether.

The number of organisations undergoing redundancy processes has already increased and going forward, not least once the government’s job retention scheme comes to an end in October, these numbers look likely to increase.

In any redundancy situation, it is important to ensure that the payments being made to employees are being taxed correctly and, where possible, that such payments are being made in the most tax efficient way. Key will be the delivery of the greatest net value to the affected employees and the lowest net cost to the employers.

This note considers the tax treatment of some of the payments which may be made to employees in redundancy situations, and sets out some of the common areas of tax difficulty and risk.

Statutory redundancy payments

A statutory redundancy payment should benefit from the GBP 30,000 exemption, meaning that such payments can be made free of income tax and national insurance contributions.

As they are excluded from the definition of “relevant termination award”, statutory redundancy payments are not subject to potential reclassification under the “post-employment notice pay” rules (commonly known as the PENP rules).

Enhanced redundancy payments

An enhanced redundancy payment will form part of the “relevant termination award” and therefore will be subject to potential reclassification under the PENP rules. To the extent that these rules result in a positive PENP figure, an appropriate part of the enhanced redundancy payment could therefore be reclassified as earnings, subject to income tax and employee’s and employer’s national insurance contributions.

The balance of an enhanced redundancy payment will benefit from the GBP 30,000 exemption, as reduced by any statutory redundancy payment or other qualifying payment(s).

Where the balance of the enhanced redundancy payment exceeds the remaining part of the GBP 30,000 exemption, any amount above the remaining GBP 30,000 exemption will be subject to income tax and class 1A (employer) national insurance contributions.

It is important to note that the contractual terms (if any) under which an enhanced redundancy payment is made should be fully considered to ensure that they are consistent with the payment genuinely being viewed as being made on account of the redundancy.

Terminal bonus risk

Often employers will seek to make the payment of all, or part, of a redundancy payment conditional upon an employee doing (or not doing) certain things, for example, meeting performance targets or undertaking extra duties, in each case, during any notice period.

Any such conditionality is likely to render the redundancy payments subject to income tax and national insurance contributions as a terminal bonus and therefore, where commercially possible, should be avoided.

If it is not possible to avoid such conditionality, employers could alternatively consider making specific payment(s) on a conditional basis. Provided such separation and conditionality is clearly documented, only the conditional element(s) should be subject to income tax and national insurance contributions.

Pension contributions

It is not uncommon for employees to make requests for all or part of their redundancy packages to be paid into their pension schemes. Whilst such payments may, in appropriate circumstances, be technically possible great care must be taken around the timing and documentation of implementing such requests. The application of the PENP rules will also need to be considered which may effectively unwind any anticipated tax benefits.

Prior redundancies/terminations

If an employee’s employment is terminated and they are subsequently re-engaged by the same employer, any historic termination payments they received from that employer which benefited from the GBP 30,000 tax exemption will reduce the amount of exemption available on any future termination. For example, if an employee previously received a GBP 10,000 tax free redundancy payment and was subsequently re-engaged by the same employer, they would only have a tax free exemption of GBP 20,000 available on their subsequent termination by that same employer.

It is therefore important to carry out due diligence checks in relation to any employees being made redundant to check if they have received any historic tax free termination payments.

Retirement benefits

Where an employee plans to retire on, or shortly after, being made redundant, there is an increased risk that all or part of any redundancy payments could be subject to income tax and national insurance contributions as a retirement benefit.

Provided that the employer is making any payments solely on account of the redundancy, and not on account of retirement, and provided that such payments are calculated on the basis of a redundancy, then the risk of such payments being viewed as retirement benefits should be low. In such circumstances, it will be important that all the facts and circumstances of any proposed redundancy payment are carefully considered, and employers should keep full records of their rationale and calculations.

Prior to commencing a formal redundancy process, and often in a bid to avoid redundancies at all, some employers may offer the opportunity for employees to take part in voluntary severance schemes. Where payments are made pursuant to such schemes there is an increased risk of taxation as retirement benefits and therefore particular care should be taken around the scheme policies and documentation, including selection criteria and associated correspondence, to help mitigate this risk.