Which Payoffs are Tax-Free?

AS writes: I need to reduce the payroll cost of my business and have gone through a redundancy process to identify a couple of employees that I will need to let go. I would like to make a payment of £10,000 – on top of the statutory redundancy entitlement – to one employee who has been with me for years. Can I make this payment tax-free, and with no tax consequences for the employee?

Answer

The award you intend to make appears to be an ex-gratia payment, writes Chris Lane, a partner at Kingston Smith LLP. For this type of payment to be tax-free in the hands of the employee it must not be made under any legal or contractual obligation. In other words, if the employee’s contract states that he or she will receive this sum when employment ceases, then it would not be classed as an ex-gratia payment and would be fully taxable under the normal PAYE rules.

Similarly, if it has been normal business practice to make this type of payment to departing employees then this would also make it taxable under the PAYE rules.

It is therefore wrong to assume that a payment is tax-free just because it is made at termination of employment. Instead, it is necessary to understand the reasons for the payment.

When employees leave a business, various types of payments may be made to them. To get the taxation correct, it is important to understand what each payment relates to and the reason for making it. For example, a payment made in lieu of notice or for holiday that has not been taken is normally fully taxable.

There is a £30,000 tax-free limit for any statutory redundancy pay, including any ex-gratia payments. If your payment is being made without any obligations, then it can be paid tax-free.