No £30k exemption from tax when you leave a job

There's a common and dangerous misconception. And I saw it again in the Sunday Times yesterday, in a piece entitled: MPs plump up their ‘golden parachute’ pay. This suggested that:

"When disgraced MP Derek Conway stands down from parliament at the next election he will receive £31,645, of which the first £30,000 is tax free."

I suppose it's possible that there is a special rule for MPs (it wouldn't be the first time) but I suspect that the reporters had fallen into the all too common trap; that of assuming that the first £30,000 is invariably exempt from tax if paid in connection with one's departure from a job.

It's not. There is no automatic exemption.

What is the position then?
Firstly statutory redundancy payments are automatically free frlom tax. But the quantum of such payments is limited. So for additional amounts, there is a tax rule that means that upto £30,000 MAY be exempt from tax. It's set out in Section 401 ITEPA 2003 (previously s148 ICTA 1988). BUT this rule only becomes relevant if certain criteria are met. No one can afford to assume that their situation will automatically pass the tests.

The basic rule is that any sums paid by an employer to an employee are subject to tax if paid in accordance with a contractual obligation, if paid for work done, if paid for work to be done or if such payments are part of the employer's standard practice when someone is asked to leave their job. That's the basic rule. Only statutory redundancy payments are definitely tax free.

So when an employer makes other payments to employees the basic rule doesn't catch them. This is where s401 comes into play. It states that any other payments are taxable too - except for the first £30,000 paid in connection with the termination of employment. But this is only the case if the payment isn't taxable in full under the normal rule. And HMRC also use another rule to challenge the tax free nature of termination payments when these are paid to people aged over 50. The argument goes that the sum is taxable as an unapproved retirement benefit.

Coming back to the case of the MP referenced above I would have expected the normal rule to apply as the payoffs are contractual and (consequently) standard practice for MPs. This may well come as a bit of a shock if they were expecting to get £30,000 tax free.

What happens if you get it wrong?
Taxpayers are required to report their 'tax free' lump sum on their tax returns. The taxman invariably checks back to determine whether relevant details were properly reported by the employer. And if HMRC are not satisfied that all is correct the taxman will then seek payment of tax from the employee. For people receiving redundancy payments in early 2009, the relevant tax returns are those for the current tax year. These will not be filed until later in the year - or as late as January 2010. It could be months later before the tax demands start being issued - long after the lump sum has been spent.

Further information
Expert advice is available to help anyone who wants to learn more about how to avoid the traps here. Simply get in touch with one of the members of the Tax Advice Network who specialise in this area.

On a related issue the Low Incomes Tax Reform Group offers a fuller explanation of the tax rules on redundancy.