New tax rules are to come into effect on 6 April 2011 under the Income Tax (Pay As You Earn)(Amendment) Regulations 2011.

Currently if a termination payment is made in excess of £30,000, the first £30,000 is generally tax free under sections 401 to 401A of the Income Tax (Earnings and Pensions) Act 2003.

Regulation 5, however, inserts a new regulation 15(A1) which allows Her Majesty’s Revenue and Customs in appropriate circumstances to determine that an employer should deduct income tax at the additional rate.

Where payments are made before 6 April 2011 and a P45 has been issued, the employer must deduct tax at the basic rate and the employee will have to account to HMRC for any further tax due under self assessment. This effectively defers any tax the employee has to pay until the end of the tax year. 

If a payment is made on or after 6 April 2011, employers will be under an obligation to deduct tax from payments made after issuing the P45 on the basis that no personal tax allowances will be applied.

Employers cannot just agree to deduct the basic rate of tax on amounts over £30,000 (and assuming the excess cannot be identified as an injury to feelings payment which is not taxable).

This means that tax will be deducted at 20 per cent, 40 per cent and 50 per cent as appropriate, a change that is likely to affect settlement agreements.

Currently it is usual for a clause in a compromise agreement to provide that the employer deducts tax at the basic rate and for the employee to provide an indemnity to the employer in respect of any additional tax which may be due.

As responsibility for deducting tax rests with the employer and therefore any errors arising from this change will fall to the employer, it is suggested that as a result of this change there is no need for the employee to provide an indemnity to the employer.

To read the new regulations in more detail, go to: http://www.legislation.gov.uk