Redundancy pay: tax-free in Britain, taxable in America

Redundancy pay is a termination payment rather than ordinary wages. GOV.UK puts the British position simply: statutory redundancy pay under £30,000 is not taxable. Britain looks at the rest of the package element by element.

As a threshold rather than an allowance. HMRC's manual explains that qualifying payments count as employment income only to the extent that they exceed £30,000, and that certain payments combine into an aggregate before the threshold applies. So several small payments can combine into one taxable total.

Below the line, nothing attracts tax at all, which is why most modest packages arrive whole.

Above it, only the excess is.

So the arithmetic depends on which elements of the package count towards the aggregate.

Statutory redundancy pay is the obvious candidate for the threshold, but it rarely arrives alone. Contractual severance usually sits beside it, and the two aggregate before anybody applies the £30,000.

Post-employment notice pay, most obviously. HMRC's guidance states that the threshold does not apply to it, so Britain taxes that part of a package in full however the settlement agreement describes it. Holiday pay and unpaid wages count as earnings and follow the ordinary payroll treatment.

The label on the payment does not decide the treatment.

The manual sets out which payments aggregate before the threshold applies.

So two packages of the same size can produce very different British tax.

In practice the breakdown is the document that matters. Ask for it in writing, because a single figure on a settlement agreement tells you nothing about which parts the threshold reaches.

As compensation, in the ordinary way. Severance is pay for employment, and the Internal Revenue Code taxes it as such, with no equivalent of the British threshold. The money is reportable whether or not Britain taxed it.

Social security and Medicare treatment follows the usual rules for wages, so the charge is not confined to income tax.

In our practice this is the part clients find hardest to accept, because the payment felt like compensation for loss rather than income.

So expect the full amount on the American return and plan from there.

Also check the withholding. Nothing on a British payslip withholds American tax, so the full charge on redundancy pay arrives as a balance due rather than as a shortfall at the margin.

Because credit relief follows tax actually paid. On the slice below £30,000 no British tax arises, so there is nothing to credit against the American charge on that same money. The relief mechanism works perfectly and has nothing to work with.

Above the threshold the position improves, because Britain charges tax there.

Our guide to the foreign tax credit carryover covers what happens to any surplus, and our double tax treaty relief service deals with the claim itself.

So the exempt part of a British package is precisely the part with no American protection.

In short, the exemption that helps you in Britain removes the very thing American relief depends on. That is the whole asymmetry in one sentence.

Sometimes, and it is the first thing to test. The foreign earned income exclusion covers earned income for services performed abroad, and severance attributable to work you did in Britain can qualify, subject to the annual cap and the usual tests.

The attribution matters. A payment for American service years is a different matter.

Our guide to the bona fide residence test sets out the qualifying conditions.

So the exclusion often does more work here than the credit, where room remains under the cap.

Then both systems look at where you did the work rather than where you stood when the money arrived. A payment that relates to UK employment usually keeps its UK character even if it lands after you have moved.

The American side asks the same question for exclusion purposes.

Timing can also move the payment into a year where you no longer qualify for the exclusion.

So check a departure date and a payment date that fall in different tax years before anybody fixes either.

Our guide to your final UK tax year covers the British side of a departure, which usually lands at the same moment.

To parts of the package, yes. Earnings elements such as holiday pay and notice pay attract National Insurance in the normal way, and employer contributions can arise above the threshold on the termination element.

That is a cost to the employer rather than to you in most cases.

It does not change the American position at all.

So National Insurance is worth understanding for the net figure rather than for the US return.

Our UK Self Assessment service picks this up where a return falls due, which happens often in a year with a large one-off payment.

You can ask, though the answer rarely offers much room. Employers structure settlement agreements around employment law and their own exposure, and the tax labels follow the substance rather than the wording.

What is worth asking is the timing.

A payment date in one tax year rather than another can change the American result considerably.

So negotiate the date rather than the description.

So raise it early. Once both sides sign the agreement, the timing and the labels hold firm, and the only remaining question is what they cost.

That is a different analysis on both sides, and it can be a better one. Payments genuinely compensating for injury or discrimination rather than for loss of employment can fall outside the ordinary termination rules in Britain, and America may treat them differently too.

The distinction turns on what the payment is really for.

A settlement agreement that bundles everything into one figure makes the argument harder.

So where part of a package compensates for something other than the job ending, ask the employer to identify it separately.

Also keep the correspondence. Where somebody pleaded a claim before the settlement, those papers support the characterisation later on.

In Britain it can, because Britain treats an employer contribution into a registered pension scheme differently from a cash payment. For an American the picture is less favourable, since US tax does not follow UK pension treatment automatically.

Treaty Article 18 governs how the two systems handle pensions.

Its first paragraph protects growth in the scheme for a US citizen. Its second paragraph, on contributions, does not survive the saving clause in the same way.

So take advice on a pension contribution out of a redundancy package before agreeing it, not after.

So treat the two paragraphs of that article separately rather than as a package. Bundling them is how advice on this goes wrong.

A sequence that settles the tax before the money moves.

With the return for the year of payment, and often through estimated tax before then. A large one-off payment can create an underpayment position long before the return goes in, because nothing withheld American tax at source.

British PAYE does not withhold US tax.

Our guide to estimated tax while living abroad explains how to avoid the penalty.

So the money needs setting aside on receipt rather than at filing time.

Then the charge still arrives, and the practical question becomes payment rather than planning. The IRS offers instalment arrangements, and the sooner you put a figure on the liability the more options remain.

Interest runs regardless of any arrangement.

Our guide to an IRS payment plan from abroad sets out the routes.

So put a number on it early, even where the cash has already gone.

Consider an American made redundant in Manchester with a package of statutory redundancy pay, contractual severance, notice pay and accrued holiday.

Britain taxes the notice and holiday elements in full. The termination element falls largely under the threshold, so most of it reaches her untouched.

On the American return the entire package is compensation. The exclusion covers part of it, because she did the work in Britain, and the untaxed slice above that carries US tax with no credit to set against it.

These figures are illustrative. The pattern holds generally: with redundancy pay, the part that felt tax-free is the part that produces the American bill.

The first assumes that tax-free in Britain means tax-free everywhere. It is the opposite of true for the exempt slice.

The second expects a foreign tax credit on money no British tax touched.

The third ignores the exclusion, which here is frequently the only relief that applies at all.

The fourth spends the package before quantifying the American charge, which turns a planning question into a payment problem.

We take the employer's breakdown and show what each element does on both returns, usually within a day or two of receiving it.

Where the exclusion is in play, we work out how much room remains under the cap for the year, because that decides how much of the package really carries tax.

Our US federal returns service covers the filing, and fees stay fixed and agreed in writing. How we work sets out the process.

If a settlement agreement is in front of you, talk to us before you sign it.