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Consultations on changes to employee taxation

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By Peter Stevens

Last month, HMRC published two discussion documents which will be of widespread interest to employers and employees or contractors alike. The first, published on 17th July 2015, concerns what is commonly known as IR35. The second, published a week later, concerns the taxation of payments made on termination of employment.

IR 35

The IR35 legislation was first introduced in 2000 to tackle the avoidance of employment taxes by requiring individuals who contract through personal service companies, but who would have been employees if they had provided their services directly, to pay tax and NICs broadly as if they had been employed. It does not affect those engaging their services who, by contracting with the personal service companies, can be sure they have no PAYE/NIC obligations.

The government considers this not working as effectively as it should be. It estimates the 10,000 people who paid tax under IR35 in 2011-2012 is only 10% of those who should be doing so, and that non-compliance with the IR35 legislation is currently costing the Exchequer £430 million per year in lost tax and NICs.

There are many legitimate reasons why people choose to work through limited companies, and the government does not want to stop them doing so, but it wants to reduce the scope to avoid PAYE and NIC’s by disguising employment in this way, and to level the playing field between direct employees and workers who contract through their own companies.

The government does not believe that abolishing IR35, or widening its scope, is the answer, or that strengthening HMRC’s compliance resources will alone be sufficient. It recognises that the problem is complex and there are no easy answers. It is open to ideas, but the discussion paper suggests two:

1. Shifting the primary responsibility on to the companies which engage the workers to consider whether or not IR35 applies, and to deduct tax and NICs under PAYE if it does. This will, of course, increase the burden on the companies, but is no different from the decision they already have to make as to whether a directly engaged individual is providing his services in an employed or a self-employed capacity.

2. Simplifying the test for determining if IR35 applies, either by aligning it with the test used for temporary workers in the agency rules, which is based on supervision, direction or control, or by treating all engagements of more than a specified minimum duration as employment.

At this stage, the government simply wants to understand the issues and explore options for reform. Comments are requested by 30th September 2015 and, if the government decides to proceed with reform, there will be a more detailed consultation, the timetable for which is presently uncertain.

It is envisaged that any change will be for tax and NICs purposes only, and will not affect substantive employment law rights.

Taxation of termination payments

The other consultation concerns the tax treatment of termination payments which, again, is a very complex area. The government believes it can simplify the law and make it easier for employers to administer and for employees to understand.

The consultation period ends on 16th October 2015 and, unlike for IR35, no further consultations are planned. The government expects to announce its decision in the Autumn Statement and publish draft legislation shortly thereafter.

Payments made to employees on termination of their employment might include, among other things, salary for the current period, accrued holiday pay, money in lieu of notice, statutory redundancy entitlement and compensation for loss of office. Generally, the rule is that anything to which the employee is contractually entitled is subject to income tax and NICs, like any other earnings, but that any non-contractual payments are not subject to NICs and the first £30,000 is exempt from income tax. There are various other exemptions, reliefs and reductions which apply to non-contractual termination payments above the £30,000 threshold.

In July 2014, the Office of Tax Simplification concluded the system was fraught with confusion and uncertainty, in particular because of widespread but mistaken assumptions about the £30,000 exemption and misunderstandings about the difference between contractual and non-contractual payments. It suggested removing the distinction between contractual and non-contractual termination payments, and aligning the tax and NICs treatment. It thought this would probably make the £30,000 threshold unaffordable, and suggested either exempting all termination payments up to a specified amount (lower than £30,000) or restricting the exemption to statutory redundancy payments.

The government agrees that aligning the tax and NICs treatment of contractual and non-contractual termination payments will remove most of the existing complexity and misunderstanding. It sees the case for providing some form of tax relief when someone loses his job, and agrees with the rationale of linking any exemption to statutory redundancy payments. However, it is concerned that employees are often unclear about their entitlement to statutory redundancy, and that many (including employee shareholders, parliamentary staff, civil servants and those employed in public office) do not qualify.

Accordingly, the government intends to introduce a new exemption, but to treat all other payments made in connection with termination of an employment as earnings subject to income tax and NICs. This will simplify the position by removing the requirement to separate the payment out into its constituent parts.

The consultation document suggests two possible bases for the new exemption:

1. A fixed amount, which increases (up to a specified maximum total amount) for each year of completed service with the same employer group after the first two years.

2. Restricting the tax and NICs relief to payments for redundancy (as defined in the Employment Rights Act 1996), without distinguishing between compulsory and voluntary redundancy, and compensation for wrongful dismissal, unfair dismissal or unlawful discrimination, without distinguishing between payments awarded by a tribunal and payments agreed between the parties.

There is no intention to tax any part of a termination payment which would normally be exempt if paid as part of salary such as, for example, payments into a registered pension scheme.

The government may retain some of the other existing exemptions, such as those for payments made on terminations due to injury or disability and for certain payments to members of the armed forces, although the exemption for foreign service may be removed for the sake of simplicity. It is interested in consultees’ views on whether any of the other existing exemptions should be retained, but suggests the simplest approach might be to remove them and treat everything as part of the termination payment, subject to the new exemption up to the specified fixed amount.

The policy intention is to support those who lose their job through no fault of their own (including voluntary redundancy), so the exemption will not apply where the employee receives a termination payment after choosing to resign, or to salary sacrifices, flexible benefit schemes or similar arrangements where the employee agrees at the start of the employment to sacrifice some of his salary in return for a tax and NICs free termination payment at the end.

The government is also considering further anti-avoidance measures, such as excluding termination payments made to employees working on fixed term contracts, or where the custom or agreement is that the employment will end after a fixed period of time, and making termination payments taxable if the employee is re-engaged to do a similar job in the same employer group within a 12 month period.

First published on

Peter Stevens, Solicitor and Chartered Tax Adviser
Partner, TWM Solicitors LLP, Guildford.

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