Termination payments – cross-border tax considerations

Almost four years have passed since new rules were introduced to simplify the tax treatment of termination payments, yet it remains an area of complexity. Following the April 2018 change treating ‘Post-Employment Notice Pay' (PENP) as general earnings, Class 1A NIC was introduced on qualifying termination payments in April 2020, followed by a tax charge on non-resident individuals’ UK-sourced PENP from April 2021. However, perhaps the most significant development for internationally mobile employees (IMEs) has been the curtailing of Foreign Service Relief (FSR) from April 2018, leading to a greater reliance on tax treaties and the supporting OECD commentary to relieve instances of double taxation.

Termination payments and tax treaties

Prior to April 2018, FSR removed elements of a termination payment from UK tax in certain cases where, broadly, an IME had spent a significant part of their employment working outside the UK. Subsequently, however, FSR has been generally limited to non-residents, meaning that a resident receiving a termination payment which is taxable both in the UK and elsewhere must fall back on the provisions of a tax treaty to identify the state in which primary or sole taxing rights arise in respect of its component parts, and correspondingly, where relief by way of a double tax credit or exemption should be applied.

In essence, for termination payments the attribution of treaty taxing rights depends on two things: firstly, the nature of the payment and then in turn, whether it is in respect of employment duties exercised in the UK or elsewhere. A termination payment often comprises different elements, some of which are contractual (e.g. payment in lieu of notice or gardening leave payments), some statutory (e.g. redundancy payments required under domestic law), and some deriving from an agreement reached upon the termination of the employment itself (e.g. enhanced redundancy, ex gratia or damages payments) – a careful assessment of these elements is essential as it drives not only the domestic tax treatment, but also the sourcing of the payment in accordance with a competent tax treaty and the supporting OECD commentary.

In February 2020, HMRC held a meeting of their Joint Forum on Expatriate Tax and NIC, at which they set out their views on the sourcing of termination payments for IMEs. HMRC consider these views to be aligned with the OECD commentary, following a general principle that the payment should be sourced in the same way as the remuneration which it is intended to replace – thus, as an example, a PILON is sourced over the notice period the employee would have worked, and to the country or countries where they would have been expected to have worked during that period, but for the termination of their employment. Notably, HMRC’s view on non-contractual ex gratia payments was felt by some to be a departure from prior practice, with a move to sourcing such payments on a ’forward-looking’ basis in accordance with Paragraph 2.8 of the OECD commentary, rather than sourcing retrospectively over the final 12 months of employment in line with Paragraph 2.7.

Whilst HMRC’s rationale was clear, being based on the limited application of Paragraph 2.7 to contractual and statutory payments only, we are aware of other treaty partners taking a different view in the sourcing of ex gratia payments, which in some instances has led to a treaty mismatch when seeking to relieve double taxation. Moreover, the guidance arising from this February 2020 meeting has not been widely publicised in the intervening two years with the upshot that some stakeholders may not be fully abreast of HMRC’s current views on this matter. Self-Assessment tax returns have recently been filed for the 2020/21 tax year and we are anticipating a strong compliance focus from HMRC in the coming months, looking at the treatment of termination payments reported in these returns.

UK payroll considerations

Another consequence of FSR’s curtailment has been the increased focus on payroll withholding when making termination payments to IMEs. Whereas beforehand a payment may simply have fallen out of charge where FSR applied, now there may be a UK payroll withholding obligation to consider before any treaty claim may subsequently be made, with a cashflow risk of ‘double-withholding’ if another jurisdiction also considers some or all of the payment taxable.

Depending on an IME’s tax residency and treaty status, special PAYE arrangements may have been agreed with HMRC during their employment, limiting withholding to a best estimate of the IME’s actual UK tax liability. However, once a P45 has been issued to a leaver these agreements fall away and are replaced by a requirement to deduct tax from any subsequent payments, using PAYE code 0T on a Week 1/Month 1 basis. To operate PAYE on a different basis would require HMRC’s agreement, though this may take weeks or months to obtain.

In light of the above, advance planning is recommended and employers should consider at an early stage whether ‘double-withholding’ may occur and the steps which could be taken to mitigate the withholding requirements and cashflow issues which may otherwise arise.

Summary

Despite the simplification agenda underpinning recent years’ changes to the UK’s taxation of termination payments, it remains an area of complexity. FSR’s curtailment has resulted in a greater need to consider domestic legislation and tax treaty provisions, with care needing to be taken in reviewing an IME’s position. The interplay and potential differences between the UK’s tax treatment and that of overseas jurisdictions must also be factored in. Now more than ever, employers should plan ahead with early consideration of the tax implications of an IME’s termination payment, understanding HMRC’s interpretation of the OECD model treaty commentary on sourcing and managing the ensuing payroll withholding obligations carefully.

For further information please contact:

• Mike Lavan
• Oshin Evans