Pay and Benefits

Redundancy can be a stressful experience without the further complication of possible tax underpayments for higher rate or additional rate taxpayers.

HM Revenue & Customs (HMRC) wants to ensure that employees facing redundancy have more accurate amounts of tax deducted from the taxable element of any redundancy pay. This will bring them closer to the correct tax figure due when the year as a whole is reconciled.

To this end, the Pay As You Earn (PAYE) regulations have been amended, and the tax code employers are required to operate on the taxable element of any redundancy pay has been changed. It’s worth pointing out, however, that the majority of redundancy payments are below the £30,000 tax-free threshold, and therefore most taxpayers will be unaffected by this change.

Previously, tax was deducted using the Basic Rate (BR) tax code on the non-cumulative (Week 1/Month 1) basis, but this amendment means that employers now have to use the zero T (0T) tax code, again on the non-cumulative basis.

The change came into force on 6 April 2011 and employers have been required to operate it from that date. It was one of a number of coding changes that HMRC told employers about in the February edition of the Employer Bulletin. Software developer customers had already been informed about it in autumn 2010.

Applying the new code

The 0T code applies to all additional cash payments that are made to a former employee after a P45 has been issued. Examples of such additional payments include pay arrears, payments in lieu of notice, unpaid holiday pay, termination payments and redundancy. Special rules apply to payments of shares where these are made after leaving.

Where possible, HMRC would normally expect employers to make these additional payments before issuing a P45. This makes things simpler because the employee’s existing tax code will apply to any payment made at this time, thus ensuring they pay the correct amount of tax.

However, sometimes payments will be made after a P45 has been issued. For payroll purposes these additional sums will have to be treated as a payment after leaving and tax code 0T will apply.

Reasons for the code change

Before the BR to 0T changes to the tax code came into force on 6 April, applying tax code BR resulted in a 20 per cent deduction of tax on the taxable element of the redundancy payment, which applies to payments above £30,000. For BR taxpayers, who are still liable to BR tax when the additional payment is taken into account, this deduction of tax would have been correct when the year as a whole was reconciled. However, for higher rate (40 per cent) and additional rate (50 per cent) taxpayers, applying code BR resulted in an underpayment of tax. An underpayment of tax could also result where the annual income of a BR taxpayer was close to (but did not cross) the higher rate threshold before any taxable redundancy payment was taken into account.

Operating code 0T (W1/M1) results in more accurate amounts of tax being deducted across all of the tax rates that apply, eg 20 per cent (BR), 40 per cent (higher rate) and 50 per cent (additional rate).

How it works in practice

For an employee who is paid monthly, the first £2,917 of any taxable payment will be taxed at 20 per cent; then amounts up to £12,500 will be taxed at 40 per cent. Any amount exceeding £12,500 will be taxed at 50 per cent. This means that in most cases taxpayers (particularly those at higher/additional rate) in receipt of an additional payment will have a more accurate amount of tax deducted, bringing them closer to the correct tax figure due when the year as a whole is reconciled. Across the taxpayer population this should help reduce both the number and magnitude of PAYE underpayments.

For example, Miss A’s income for the tax year is £48,000. In addition to this, she receives a redundancy payment of £40,000 (including a taxable amount of £10,000). Using the previous BR tax code, Miss A would have underpaid her tax by £2,000. However, under code 0T, she would face a smaller underpayment of £584.

Overpaid tax

Separately, as a result of this code change, some BR taxpayers may have too much tax deducted when their redundancy payment is made. If a customer thinks that they have paid too much tax on their redundancy payment, depending on their circumstances, they should be able to make an in-year claim for any overpaid tax to be repaid. Customers should contact HMRC to claim any refund they may be owed. They will need to provide certain information, typically the P45 issued by their previous employer, details of the redundancy payment and the tax paid on it. Further information is available at www.hmrc.gov.uk/incometax/stop-work-refund.htm.

If the customer has stopped working or is claiming Jobseeker’s Allowance, taxable Employment and Support Allowance or taxable Incapacity Benefit, HMRC will send them any tax refund that they are entitled to. It aims to process the claim within 15 working days. The actual refund will be sent separately and will take a little longer to arrive. If the customer has started a new job, providing they are on a cumulative tax code, their new employer will be able to pay any refund due to them through the normal operation of PAYE. As part of HMRC’s standard review processes we will continue to monitor these new arrangements going forward.

Further information on redundancy can be found at www.hmrc.gov.uk/guidance/redundancy-factsheet.pdf.

Val Hennelly is Employment Income Team Leader at HMRC