Taxation of Payments Made After the Termination of Employment

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1 Number March 2011 Client Alert Latham & Watkins Tax Department A number of important taxrelated changes that will affect employers and employees in the UK will take effect from 6 April Important Employment-related Tax Changes from 6 April 2011 A number of important tax-related changes that will affect employers and employees will take effect from 6 April The key changes that are relevant for employers are: i) the taxation of payments made after termination of employment; ii) disguised remuneration; and iii) childcare vouchers. This Client Alert summarises these changes, along with certain other changes which will also be implemented on 6 April Taxation of Payments Made After the Termination of Employment With effect from 6 April 2011 a new tax code will apply to payments made to employees after their employment has terminated and they have been issued with a P45. A P45 is a document issued to departing employees which records the employee s earnings and the tax that has been deducted from those earnings in the tax year in which their employment terminates. Currently, when an employer makes a payment to an employee after their employment has terminated and they have been issued with a P45, the employer is only required to deduct income tax at the basic rate (20 percent) from that payment. This is the case even if the employee would ordinarily be a higher rate or an additional rate tax payer (i.e. they would ordinarily pay income tax at 40 percent on earnings above 35,000 or 50 percent on earnings above 150,000). This usually applies to post-termination payments such as payments in lieu of notice, bonuses, and any taxable compensation payments. Under the current rules, the employee is responsible for accounting to HMRC personally for any additional tax due at the end of the tax year if their total earnings in that tax year mean that they should have been taxed as a higher rate or additional rate tax payer in respect of those termination payments. With effect from 6 April 2011, the employer will be obliged to use this new tax code when making termination payments regardless of the tax band which the employee in question falls into. This means the payments will be taxed as if they were made in the ordinary course of employment. The employer is therefore required to deduct income tax from the termination payments at the appropriate tax rate (i.e. 20 percent for basic rate tax payers, 40 percent for higher rate tax payers or 50 percent for additional rate tax payers). Although this will not increase the cost of making termination payments for the employer, employers should take note of this change as ensuring that the correct amount of income tax is deducted from a payment made to an employee is always the responsibility of the employer. Employers need to Latham & Watkins operates worldwide as a limited liability partnership organized under the laws of the State of Delaware (USA) with affiliated limited liability partnerships conducting the practice in the United Kingdom, France, Italy and Singapore and an affiliated partnership conducting the practice in Hong Kong and Japan. Latham & Watkins practices in Saudi Arabia in association with the Law Office of Mohammed Al-Sheikh. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2011 Latham & Watkins. All Rights Reserved.

2 be careful that the correct amount of tax is deducted in order to avoid the risk of HMRC imposing penalties and interest on the employer. This new approach will apply to posttermination payments such as payments made pursuant to a compromise agreement and employers should review any standard form compromise agreements to ensure they provide for the correct tax deductions after 6 April The first 30,000 of any ex-gratia payment paid as compensation for termination of employment pursuant to a compromise agreement can still be taxfree, in line with the pre-6 April 2011 position. Employers should also bear in mind that this change may affect the administration of employee share schemes where shares are issued or transferred to an employee after their employment has terminated. As with any other post-termination payments, instead of applying the basic rate, the new tax code will apply and the employee s shares will be taxed at the appropriate rate. Disguised Remuneration In December 2009 the UK Government published draft anti-avoidance legislation for the Finance Bill 2011 to put an end to arrangements using employee benefit trusts (EBTs) in a way which avoids or defers liability for income tax or National Insurance contributions (NICs). These new rules will be implemented with effect from 6 April Under this new legislation, income tax charges (and therefore the employer s obligation to collect tax under the Pay-As-You-Earn PAYE system) will arise immediately when, under an arrangement to provide rewards, recognition or a loan, a relevant third person: Earmarks (however informally) a sum or asset for; Pays a sum (including a loan) to; or Makes an asset available to benefit, a current or former employee or director, or person linked to such current or former employee or director. The key trigger for this new legislation is the involvement of a third party in the provision of the benefit. For example, sums or assets earmarked (e.g. by placing the asset in a subtrust or subfund) for or loaned to employees by EBTs will be treated as though the amount of the sum or the value of the asset is, at the time it is earmarked or loaned, a payment of taxable income to the employee. Loans provided to employees by EBTs will be treated as though the value of the loan is a payment of taxable income. Therefore the income tax and NICs become due immediately, and it is the responsibility of the employer to account for these amounts to HMRC via PAYE. Concerns The new rules have raised significant concerns among employers as they are very broadly drafted and will potentially apply even in circumstances where no tax avoidance is intended. Very Narrow Exemption for Tax- Favoured Option Plans Tax-favoured employee share and share option plans are exempted, as are registered pension schemes, the grant of employment-related securities and the acquisition of restricted securities subject to a forfeiture restriction lasting five years or less. However, as drafted, these exemptions are very narrow. For example it is not clear whether the exemption in respect of approved and unapproved employee share option plans will apply to steps taken outside of a plan. For example if the employer funds an EBT so that it can acquire shares on the open market to grant to employees pursuant to an employee share plan, will this action of putting the EBT in funds be sufficiently connected to the plan to be exempt from the new rules? Alternatively, will this step be seen as a taxable earmarking of funds? If the latter, then a tax charge would effectively arise before the employee has received any benefit from which to fund the tax liability. 2 Number March 2011

3 Employee Loans and Cashless Exercise An additional concern is that by capturing all employee loans without any relief for repayment of the loan, a tax charge could arise where a cashless exercise facility is put in place in relation to share options. Cashless exercise facilities are often used in the context of a corporate transaction to allow optionholders of the target company to fund the exercise price of their options from the proceeds of sale of the underlying shares that they will receive at completion. Technically this type of arrangement could be classified as a loan. These are fairly common arrangements, particularly where EMI or approved option plans are in place as it enables the optionholders to exercise their options prior to the change of control and thereby protect the associated tax benefits. Interaction with New FSA Remuneration Code Another area of concern is how these new rules will operate in conjunction with the new FSA Remuneration Code which was implemented on 1 January 2011 (see upload/pubcontent/_pdf/pub4026_1. pdf). The FSA Remuneration Code requires certain FSA regulated firms to remunerate certain employees through deferred share awards which is likely to lead to more employers using EBTs to warehouse shares for awards. Unless HMRC issues further guidance dealing with the points above, there is potential for tax to arise on deferred remuneration which the employee has not yet received which will be difficult for the employee to fund. Some Rules Already in Force For the period from 9 December 2010 to 5 April 2011 anti-forestalling charges apply to employees who receive payments or who benefit from cash loans (or the use of assets as security for cash loans e.g. a mortgage over a home) in a way that would be chargeable if it occurred after 6 April In this way the new legislation will have retroactive effect from 9 December 2010 as these payments will be taxed as if they were paid/loaned after 6 April Anti-forestalling charges only become payable on 6 April 2012 (presumably to give time to unwind arrangements) if by that time the money has not been repaid or the relevant asset has not been returned or ceased to be used as security. HMRC have published Q&As which suggest that some amendments may be needed to alleviate some of the problems outlined above. We will report further as soon as these amendments are published. Childcare Vouchers In the UK employers may assist their employees with the financial aspects of their childcare requirements in the form of childcare vouchers, directly contracted childcare, or providing on-site childcare facilities. The UK Government supports these initiatives by offering income tax and social security contribution relief. For example, childcare facilities provided by an employer on site are, subject to certain conditions being met, entirely exempt from tax and NICs without limit. The more common approach is however to provide childcare vouchers and it is estimated that 20 percent of UK employers provide childcare vouchers. Under a typical childcare voucher scheme an employee will sacrifice a portion of their gross salary (up to 243 per month) in return for a voucher of equal value which can be redeemed at a childcare provider. This sacrificed amount will not be subject to income tax or NICs which essentially allows the employer to provide a tax free benefit to the employee. As the employer is not required to pay employers NICs on this sacrificed salary there is a considerable incentive for employers to implement childcare voucher schemes. However, the level of this income tax relief will be reduced with effect from 6 April 2011 for any employees who are 3 Number March 2011

4 newly joining an employer-supported childcare scheme. Employees who have already joined their employer s scheme before 6 April 2011 will not be affected and these changes will only apply to childcare voucher schemes and directly contracted childcare; employers who provide workplace nurseries will not be affected. The changes are being introduced so the amount of tax that an employee saves when they receive childcare vouchers is the same for all employees, regardless of the rate at which their earnings are taxed. With effect from 6 April 2011, all employees newly joining a childcare scheme will receive tax relief at the basic tax rate (i.e. 20 percent). This is to address the fact that, currently, employees who are higher rate tax payers (i.e. income tax is deducted from their earnings above 35,000 at a 40 percent rate) or additional rate tax payers (i.e. income tax is deducted from their earnings above 150,000 at a 50 percent rate) receive a greater tax saving than those who are basic rate tax payers (i.e. income tax is deducted from all of their taxable earnings at a 20 percent rate because they do not earn more than 35,000 per annum). Basic rate taxpayers will therefore not be affected by this change. However, it may be advisable for any eligible basic rate employees who are not currently members of an employersupported childcare scheme to join any such scheme before 6 April 2011 to ensure that if they become a higher or additional rate taxpayer in the future they will be able to benefit from tax relief on any salary sacrificed for childcare vouchers at those higher tax rates. Other Increase in National Insurance Contribution rates In the UK employee remuneration is generally subject to NICs which are effectively social security contributions. There are two NIC charges: 1. Primary or employee s NICs is a withholding charge that the employer deducts from payments made to the employee and pays to HMRC. 2. Secondary or employer s NICs is an additional cost which the employer must pay to HMRC i.e. it cannot usually be withheld/ deducted from payments made to the employee. With effect from 6 April 2011 employee s NICs rates will increase from 11 percent to 12 percent for earnings between the primary threshold (which is 139/week) and the upper earnings limit (which is 817/week) and from 1 percent to 2 percent for amounts earned above the upper earnings limit. Perhaps more pertinently for most employers, employer s NICs will increase from the current rate of 12.8 percent to 13.8 percent effectively adding to the employer s existing employment costs. Employer s NICs can only be passed on to an employee where they arise in the context of employment related shares (or other securities) or share options (or other share based incentives). In those circumstances the employer can require the employee to enter into an agreement whereby the employee assumes the employer s NICs or, enter into a joint election with the employer, in a form approved by HMRC to the same end. Employers should consider whether they can accelerate payment of amounts due, e.g. bonuses, so they are paid before these higher NIC rates apply. 4 Number March 2011

5 Pensions The UK pensions regime will see some important tax changes applying from 6 April The previous UK Government had planned to introduce a high income excess relief charge applying to pension plan contributions or accruals for individuals earning over 150,000. This approach was much criticised by opposition politicians and industry bodies alike. The coalition Government has announced that instead it will reduce the annual allowance and the lifetime allowance. The annual allowance, currently set at 255,000, is the annual limit on the amount of saving (broadly, increase in benefits or size of the individual s pensions pot ) in a pension plan currently allowed without triggering tax penalties. It will be reduced to 50,000 from 6 April 2011 i.e. tax charges will be levied on any pension saving above this amount. The tax charges will be at the individual s marginal rate of tax up to 50 percent for the highest earners. Those who have not used up their full annual allowance in previous tax years will be able to carry forward the excess for three years, which will protect those who do not normally have high accruals but who have a significant increase in a particular year, for example because they have been made redundant and receive additional pension benefits as part of the package. The annual allowance charge will continue to be collected through the process of tax self-assessment, with a fixed amount, as yet unsettled, to be paid from the individual s income and the balance to be collected from his pension benefits. The lifetime allowance, currently set at 1.8m, is the total amount of saving in a pension plan an individual can build up during his lifetime without tax penalties applying. It will reduce to 1.5million from 6 April Number March 2011

6 If you have any questions about this Client Alert, please contact one of the authors listed below or the Latham attorney with whom you normally consult: Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorney with whom you normally consult. A complete list of our Client Alerts can be found on our website at If you wish to update your contact details or customise the information you receive from Latham & Watkins, please visit to subscribe to our global client mailings program. Catherine Drinnan catherine.drinnan@ lw.com Sarah Dunkley sarah.dunkley@ lw.com Gretchen Lennon gretchen.lennon@ lw.com Abu Dhabi Villiers Terblanche Barcelona Jordi Domínguez Beijing Allen C. Wang Brussels Howard Rosenblatt Chicago Robin L. Struve Sandhya P. Chandrasekhar Doha Villiers Terblanche Houston C. Timothy Fenn Los Angeles James D. C. Barrall David M. Taub Laurence Seymour Joseph B. Farrell Madrid Jordi Domínguez Milan Fabio Coppola Moscow Christopher J. Allen Paris Agnès Cloarec-Mérendon Matthias Rubner Riyadh Mohammed A. Al-Sheikh Rome Fabio Coppola San Diego Holly M. Bauer San Francisco Linda M. Inscoe Scott D. Thompson Shanghai Rowland Cheng Dubai Villiers Terblanche Frankfurt Hans-Jürgen Lütt Hamburg Stefan Lunk Norma Studt Hong Kong Simon Berry Jane M. S, Ng Munich Claudia Heins New Jersey David J. McLean New York Jed W. Brickner Bradd L. Williamson John D. Shyer Orange County David W. Barby Silicon Valley James A. Metz Singapore Chei Liang Sin Tokyo Michael J. Yoshii Hiroki Kobayashi Washington, D.C. David T. Della Rocca Number March 2011