Goodbye, job hello, taxman

Job Losses seem to happen with depressing regularity, but at least the blow is often softened by a pay-off. The ex-employee departs, not exactly happy, but with something of a nest-egg to keep him going until the next job.

As that nest-egg is counted, thoughts may turn towards tax ... But surely there isn't tax on a redundancy pay-off? Surely it's tax-free? Even if there is tax, the first pounds 30,000 is tax-free, isn't it?

Unfortunately, not all pay-offs escape the Inland Revenue's clutches - and that pounds 30,000 exemption isn't always available. This is an area of increasing attention from the taxman. The argument is usually over what is strictly a pounds 30,000 exemption on a "payment for loss of office". If you lose your job and get a payoff, then fine, the first pounds 30,000 is tax-free.

The problem is, was the payment really for losing your job? Increasingly, the Revenue is arguing that pay-offs come from the employment contract and therefore are something to do with the job - not with losing it.

This may seem like splitting fiscal hairs. But the exemption costs the Revenue about pounds l.5bn a year, so it is paying close attention. And under special scrutiny now are payments in lieu of notice (Pilons).

A straight redundancy payment, often under statutory rules, will always qualify for the pounds 30,000 exemption. So will an ex gratia payment - if it is really paid out of the goodness of the ex-employer's heart and without any obligation. The problems start when there is an alleged obligation on the employer.

Often, individuals get an extra amount, possibly when they are being asked to leave quickly. This is the Pilon that is under attack from the Revenue. But is such a payment really taxable? Much can depend on the wording of the employment contract.

The Revenue argues that if the contract specifically says an employee is entitled to a Pilon on leaving, the payment comes from the job rather than from losing it. The taxman makes a similar point if the employer has discretion to pay a Pilon. It even tries to argue that if the employer starts to make a habit of paying Pilons, that raises expectations and thus means it's all coming from the contract.

My feeling is that the Revenue is on shaky ground with many of its claims. Fundamentally, the pay-off is coming from losing the job, not from the contract.

But the Revenue's efforts in this area have been buoyed by a recent case involving Thorn EMI where contractual Pilons were held to be taxable as if part of salaries rather than part of the redundancy amounts qualifying for the pounds 30,000 exemption. This case may go to appeal, but the Revenue does seem to have won a battle in what is becoming a drawn-out war.

So what can the employer, or the ex-employee, do? Companies will, after all, be the first line of attack for PAYE and National Insurance contributions on pay-offs.

The first point to note is that some payments are always going to be regarded as taxable in full. If you get a pay-off for finishing current projects or for "gardening leave" (where people are sent home to kick their heels rather than rush off to join the competition) then expect the payment to be taxed in full. But on anything else - argue.

Particular care needs to be taken if someone near retirement age is leaving. While contributions to the pension scheme would normally escape tax, a cash pay-off may be taxed as an "unapproved" pension scheme.

If there is scope for having contracts of employment that do not mention the possibility of a Pilon, that helps. For just such a reason, some employees are now finding that their employers are trying to change the contracts. This is all very well, but naturally enough, not all employees want to lose the promise of a Pilon if the worst happens.

In some cases, separate side agreements are being drawn up distinct from the employment contract when somebody is leaving or indeed signing up for their contract. That in itself raises additional problems, as the Revenue has yet another weapon in its armoury dealing with payments during a contract for "giving an undertaking".

All in all, this is a far from ideal situation. Losing a job is a traumatic enough experience - but finding that some of your pay-off has disappeared in tax is hardly calculated to make you feel better.

Employers are best advised to take care, and preferably advice, in this area to ensure that their employees do not lose out. After all, they may be leaving you but you do want them to go off with a good feeling and not an unnecessary tax bill.

q John Whiting is a tax partner with Price Waterhouse.