The 'Tax Simplifier' series aims to make the case for a much simpler tax code with practical recommendations for policy change. Blogs are published twice a week, on Monday and Thursday. Read David's previous blog on artificial tax planning. You can follow David on Twitter @TaxSimplifier.
Tax complexity can affect ordinary people, not just big sophisticated businesses.
Suppose for example an employee (let’s call him “Tom”) is paid a lump sum when he leaves his job. Tom wants to understand whether he is exempt from tax on this payment. Some termination payments of up to £30,000 can be received tax free.
No exemption will be due if the payment is actually for work done. So if the employer is imprudent enough to send a letter saying: “Thank you Tom for doing a great job for us - the board have decided to make you an ex gratia payment of £30,000”, HMRC would probably tax it. The first half of the sentence looks natural enough. But unfortunately for Tom it will give HMRC the evidence they need to tax the payment.
Or suppose the payment had been made as part of an arrangement whereby Tom continued to work for a short period. HMRC might again tax it as a reward for work done.
No exemption will be due if it was made under the contract of employment. So if Tom’s contract provides for a termination payment in lieu of notice then it will be taxable. If the contract does not say this is it may be tax free, even if calculated in exactly the same way.
No exemption will be due if the payment is made under a non-approved retirement benefit scheme.
As with everything above, the scope of this rule is vague - when does a person “retire”, and when do arrangements or an understanding with employees constitute a “scheme”.
Suppose Tom escapes tax under these rules - he still may not actually gain anything!
This is because, under the “Gourley principle”, compensation due on a breach of contract is calculated by putting the employee in the same after-tax position as if there had been no breach. Suppose the payment is made to compensate for loss of earnings and is paid tax free. Unfortunately for Tom, the amount of tax he would have paid on his earnings had the contract continued is deducted from the compensation payment. So the employer who breaches the contract may effectively benefit from the £30,000 exemption instead of Tom!
This is just a bare outline of the issues. The HMRC Employment Income Manual has 112 pages on this topic. Or for an alternative guide see Tolleys “Tax on Termination Payments”, 2011, priced at £39.95.
Unfortunately, even if he masters all this guidance, Tom will likely feel that the answer in his own case is not clear cut. He (and/or his employer) may have a long argument with HMRC ahead.
Such arguments over tax law can sometimes seem to take place in a parallel universe disconnected from fulfilling any purpose in the real world. This is because, as a recent report from the Office of Tax Simplification confirmed, the underlying policy for the exemption is not clear.
There is a solution to all this. And that is to tax all termination payments, save, perhaps, for the amount of any statutory payment on redundancy.