Matthew Rumbelow looks at negotiated settlements and the tax liabilities.

Marconi's dire profits warning last week came as no surprise after the firm announced in July that 4,000 redundancies were to be made globally, with 1,500 of those expected in the UK. July also saw BT and NTL announce their own redundancy programmes involving 8,500 employees, while recent figures show that Motorola has lost more than 20 per cent of its workforce since last December.

Common to most redundancy programmes is the concept of an ex gratia severance payment. A severance payment contained in a compromise agreement serves two purposes. First, it acts as an insurance policy for the employer against litigation or the continuation of outstanding claims, and secondly, it can off-set the shock of unemployment. Occasionally, cash payments are also joined with other benefits. In June this year, Guinness offered its employees the liquid incentive of a ten-year beer supply, alongside an £80,000 university scholarship fund and a donation of £4,000 to a pensioners' social club.

Elaborate schemes, such as the payment of sums into short-term off-shore trusts, have so far failed (Westmoreland Investments v McNiven). Sums may be paid tax-free to pension schemes or in relation to out-placement services provided on redundancy, but the main provision usually relied on is the Inland Revenue tax concession under SI48 and SI88 of the Income and Corporation Taxes Act 1988 ("ICTA") whereby an employer can legitimately make a tax-free lump-sum payment up to £30,000 as compensation for loss of office or employment.

But there are limitations, and employees and employers should resist the temptation to amalgamate contractual entitlements with an ex gratia payment to arrive at a global figure labelled as "compensation". Severance payments are increasingly being scrutinised by the Inland Revenue, and it is essential that payments made in accordance with the employee's contract are correctly subjected to deductions for PAYE and National Insurance contributions. Recent cases have paid particular attention to the issue of payments in lieu of notice. Where a contract contains an express right to make a payment in lieu of notice, or if there is an established custom and practice that could amount to an implied term, any payment in lieu of notice will be taxable.

Employees in a hurry to take advantage of amalgamated lump-sum payments tend to overlook the tax indemnity clause buried in their compromise agreement. A tax indemnity in the employer's favour means that if there is any future tax burden or fine, it is the employee who will be forced to pick up the tab.

In the recent case of Richardson (HM Inspector of Taxes) v Delaney, even genuine, stand-alone compensation payments are no longer necessarily tax exempt up to the £30,000 limit. Mr Delaney was put on garden leave during his notice period, and a lump sum payment was negotiated. His employment was then terminated prior to the expiry of his contractual notice period. At first instance it was held that the lump sum could not represent a contractual payment because his notice had been cut short, and would therefore fall under the ICTA exemption.

Not so, said the High Court. Because the payment was negotiated prior to the termination of his employment, and therefore before any breach of contract had arisen, the payment was taxable in full under PAYE as a contractual emolument.

In short, unless the employer has already breached the employee's contract, negotiated settlements while the employee is in situ may be taxable in full.

First published in The Times on 11 September 2001.