Tax Traps, Tricks and Tips

Many years ago the late George Carmen QC was defending Ken Dodd, who faced charges of tax evasion.  Mr Dodd blamed his Accountant for failing to make the proper declarations to HMRC.  George Carmen, in summing up to the jury, said, “Comedians should not be Accountants, but sometimes Accountants can be comedians”.  Mr Dodd was acquitted.

Similarly Employment Lawyers should not become Accountants.  However some knowledge of the tax treatment of sums negotiated and payable upon the termination of employment is useful.  Complex and high value arrangements will always be referred to Accountants, who in turn may contact HMRC to obtain advance clearance in regards to a particular arrangement.  Nevertheless two recent cases which went to the First Tier Tribunal (FTT) provide some useful guidance on how best to approach high value termination arrangements.

It is common knowledge that the first £30,000 of a termination payment can be paid free of deductions for tax and national insurance.  Whether that sum can properly be paid without deductions is for the HMRC to decide if it should enquire into the particular circumstances.  Typically this will be when an employee leaves under the terms of what is now called a Compromise Agreement, and will shortly be called a Settlement Agreement.

The question to determine the tax treatment of the termination payment is whether or not the money is a genuine ex gratia termination payment which ‘buys out’ the right of the employee to make claims against the employer (for, example, Unfair Dismissal or Discrimination)?  This payment reflects damages which the employee may be entitled to if s/he sues, and is not taxable.  Or is it based on monies the Employee is entitled to under the Contract of Employment?  So, accrued holiday pay, notice pay, payment relating to a period of “gardening leave”, bonus or commissions would normally all be taxable at source.  The rule of thumb is, if the employee would have been taxed on this payment during employment, then s/he should be taxed after employment.

Difficulties can arise if a Compromise Agreement does not distinguish, and separate out, the constituent parts of the termination payment so it is self-evident whether or not a liability arises.

In the cases of Reid v HMRC and Johnson v HMRC, the lawyers who advised on the Compromise Agreements were content for the Contract to refer to a global termination payment.  But both employees received payments in excess of £70,000 and both utilised the tax free exemptions.  Mr Reid was found to be liable for tax on a large portion of his payment.  As a rule the liability for arrears of tax, together with penalties and interest, falls on the shoulders of the employee.  Mr Johnson avoided a liability but only because he was successful in persuading the FTT to look at surrounding evidence to show how the payment was made up, rather than just the Compromise Agreement.  Nevertheless, he would still have incurred legal fees in defending the action by HMRC.

So when it comes to drafting, or advising upon, Compromise Agreements, employment lawyers do not need to be Accountants, but should definitely avoid becoming comedians.

For more information please contact Rothera Dowson’s employment specialist Paul Brill on 0800 046 3065 or visit the Rothera Dowson employment law website.