Are redundancy payments tax deductible?

Tax deduction - different situations

Before we dive into the nitty-gritty of the tax rules, to answer the question about deductibility it’s important to consider the two broad circumstances in which a redundancy payment can be made as they can affect the tax deductibility for the employer.

Reasons for redundancy

The first circumstance applies only to an ongoing business, and the second only when an employer’s activity completely ceases. The latter situation is self-explanatory while the first might occur for one of two reasons: typically, either where only part of a business ceases to trade or where a business is scaling down and no longer needs as many staff.

Example. Acom Ltd manufactures widgets. It sells them to widget wholesalers but also to the general public through its retail factory shop. Acom decides to close the shop because it’s no longer worthwhile. This makes the shopworkers’ jobs redundant.

Business continuing to trade

In our example Acom is entitled to a tax deduction for the redundancy payments it makes to the shopworkers under the general tax rules for expenses. These permit tax relief as long as the expenditure is incurred “wholly and exclusively for the purposes of the trade”.

Business ceasing to trade

A tax deduction for redundancy payments can’t be allowed under the general rules because the trade is ending. The good news for businesses (whether they operate through a company or not) is that special rules exist to allow tax relief for redundancy payments where a business ceases to trade.

The difference matters

As we’ve already mentioned, different tax rules apply to allow tax relief for redundancy payments in different situations. Importantly, this means that there’s no limit on the amount of tax relief that can be claimed for a redundancy payment made by a business that continues to trade. For continuing trades HMRC won’t usually challenge the amount deducted for redundancy payments as it assumes that a business will negotiate such payments and thus they meet the “wholly and exclusively” condition. A possible exception to this Tip is where the redundancy involves a director who also owns shares in the company which they are selling as part of their exit.

Statutory limit

For redundancy payments linked to the closing down of a business, special rules impose a limit on the amount that the employer can claim as a tax deduction. The amount is the greater of the statutory redundancy payment the employee would get and the amount they are entitled to under the terms of their employment contract but only up to three times the statutory amount. The tax rules do not limit the amount of redundancy payment, only the amount of tax relief.