Severance package refers to benefits which an employee receives at the end of an employment. They are typically offered to employees who are laid off (redundant) or retired. Sometimes, they may be offered to employees who resign, regardless of the circumstances. Severance package has become an increasingly popular tool for employers to manage the winding up of an employee-employer relationship.
The concept of severance pay is to maintain good relationship with the exited employees who have fallen victim of an organization’s downsizing (or rightsizing) exercise. It is also used as a tool for crisis management in cases of employees lay off resulting from company acquisition to avoid litigation or other negative reactions by the exited employees. Severance pay may comprise of compensation for loss of employment and/or payment in lieu of a required notice period, gratuity payments; including any additional payments for unused vacation time or sick leave as well as any outstanding employee’s regular pay.
A typical example of severance pay is “compensation for loss of employment”. Generally, compensation for loss of employment covers payment for cancellation of contract such as damages, arbitral award, negotiated amount, ex gratia amounts etc. which are not included in the original contract of employment.
The importance of the concept of severance package is emphasized in section 20(2) of the Nigerian Labour Act, Cap L1 LFN, 2004. The section provides that the Federal Minister for Employment, Labour and Productivity may make regulations providing for the compulsory payment of redundancy allowances on the termination of a worker’s employment because of his redundancy. Redundancy, in the section, means an involuntary and permanent loss of employment caused by an excess of manpower.
Two tax legislations readily come to mind when considering the personal income tax consequences of severance pay. They are Personal Income Tax Cap P8 LFN 2011, as amended (PITA) and Capital Gains Tax Act CAP 42 LFN 2004 (CGTA). Based on the provisions of paragraph 26 of the Third Schedule to PITA, “any compensation for loss of employment” is exempted from personal income tax. However, Section 6 of CGTA imposes capital gains tax (CGT) at 10% on “any capital sum derived by way of compensation for any loss of office or employment”.
Unfortunately, CGTA did not define what constitute “capital sum”. It is therefore a subject of technical debate whether all or any part of compensation for loss of employment exempted under CGT will attract capital gains tax.
It is arguable that the rationale for exempting compensation for loss employment under PITA is to shield an exited employee from double jeopardy and to enable him enjoy some measure of relief from the burden of tax on the compensation received. Consequently, where the compensation is triggered strictly by loss of employment, it will be exempted from personal income tax (PIT) pursuant to the provision of paragraph 26 of the Third Schedule to PITA.
It will appear that the mode of settlement does not matter as far as PITA is concerned as “any compensation” paid in pursuant of a loss of employment is exempted.
It must be noted that salaries and allowances and any other payment that may be received at the end of employment would be taxable. The test is to determine whether the employee would have received the benefits if he or she had continued in employment. Where the answer is yes, it would not qualify as compensation for loss of office.
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