With effect from 6 April 2011, employers can no longer simply
deduct basic rate tax (currently 20%) from cash termination
payments made to employees after the issue of their P45.
New PAYE Regulations which came in to force from 6 April instead
require employers to use an "OT" code to calculate and
deduct tax where the employee's P45 has already been issued.
The effect is a potential requirement to deduct basic, higher and
additional rate tax from the payment.
Background
Where an employer makes a termination payment to an
employee, it will normally be required to withhold tax at source in
respect of any amounts that do not fall within the tax free
exemption provided by section 401 of the Income Tax (Earnings and
Pensions) Act 2003. This exemption only applies to the first
£30,000 of a qualifying termination payment and so
withholding will be required in respect of any excess over
£30,000.
The position prior to 6 April 2011
Previously, employers were permitted to deduct only basic rate tax
(currently 20%) from non-exempt termination payments made after the
issue of the P45, using the "BR" code. This provided a
cash-flow advantage to employees who were higher/additional rate
tax payers, as the higher rates of tax owed in relation to the sum
would not be payable by the employee until after that employee had
subsequently filed their individual tax return with HMRC.
The position with effect from 6 April 2011
HMRC has altered the position with effect from 6 April,
no doubt with a view to reversing this cash flow advantage in its
own favour.
For payments made on or after 6 April where the P45 has already
been issued, the employer will now have to calculate and withhold
tax using a non-cumulative "OT" code. A further key
aspect of the change is that deductions under the "OT"
code will be calculated by reference to 1/12th of the
employee's annual basic, higher and additional rate
bands.
The "OT" code at a glance
By way of illustration, the PAYE withholdings that would have to
be applied to any post-P45 cash payment made in the first month of
the 2011-12 tax year ("month 1") will be roughly as
follows:
The first £2,916.67 would be taxed at 20% (being one twelfth
of the £35,000 threshold for the 20% tax band for
2011/12);
The next £9,583.33 would be taxed at 40% (being one twelfth
of the £150,000 threshold for the 40% tax band for 2011/12);
and
Any amount above £12,500 would be taxed at 50% (as being
over one twelfth of the £150,000 top rate
threshold).
HMRC has published
guidance to assist employers in using the new code.
Payments made prior to the issue of the P45
The PAYE treatment of payments made prior to the issue of
the P45 remain unchanged. Employers are obliged to withhold tax on
any non-exempt termination payments at the rates that would have
applied had that payment been additional salary/income paid to the
employee.
Steps to take
Employers should take steps to ensure that their Human Resources
and payroll teams are aware of this change and of the fact that it
is no longer desirable (for employees at least) to delay
termination payments until after the issue of the P45.
Employers should also check that their payroll operators are aware
of the change, so that they operate the "0T" code where
necessary going forward.
Options
Employers who wish to limit the impact of this change for
employees should consider either making the termination payment
before the P45 is issued, or staging the payments made after the
P45 has been issued over several months.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
