Those who have been fortunate enough to be employed know at the back of their minds that nothing is permanent, least of all formal employment. However, one thing that most people look forward to is the severance pay at the end of service or in the event that your contract is terminated. Whether you left employment voluntarily or otherwise, payments received upon retirement or termination of your contract are taxable. So, what do you need to know on the procedure of taxing lump sum payments? A lump sum payment refers to a one-time large payment of money that is given to an employee. It may include gratuities, bonuses, and severance pay. 

Every employer is required to recover the appropriate tax from any lump sum amount before releasing the balance to the employee. When a lump sum amount is paid to an employee in a year of income that is different from the year that it was earned, such income is considered to be income of the year it was earned.

So how do you calculate tax on the lump sum payment? Take the total taxable pay for the year and add the lump sum amount for that year, calculate the tax payable on the revised total taxable income using the annual individual tax rates. Deduct the personal relief and the total PAYE that is already paid. The balance is the tax payable on the lump sum.

Compensation for termination of a contract of employment or services is also taxable. When the contract is for a specified term, the amount received is considered to have been earned evenly and is assessed over the unexpired period. When the contract is for unspecified term and provides for terminal payment, the amount paid is spread forward and taxed at the rate equal to the employee’s gross pay per annum received immediately before termination. If the contract does not provide for compensation, the amount paid as compensation is considered to have accrued evenly over three years’ period immediately following the termination.

Payment in lieu of notice is taxed immediately after the date of termination of employment. Leave pay should be taxed in the year to which it relates. If termination of employment occurs in the course of the year, the portion of lump sum payment for that period is taxable in that particular year.

Example:

Mr. Peter Bakari left employment in September 2016 after 30 years of service and was paid severance pay/service gratuity of Kshs. 660,000; three months’ notice pay of Kshs. 90,000 and Kshs. 25,000 for his 20 leave days not taken for the year 2015. For the purposes of calculation of tax payable, the service gratuity amount is to be spread backwards and taxed together with income earned in the relevant years but notice pay is assessable in the period immediately after date of leaving employment and pay instead of leave should be taxed in the year to which the leave days relate (i.e. 2014, 2015 etc.)

The procedure on how tax should be calculated is outlined below: -

In conclusion, when taxing lump sum payments, the income is spread backwards for five years and assessed together with income earned in the prior years. The balance is taxed in the fifth year. It is important to note that the methods outlined above apply to all employees including whole time service directors. To ensure compliance, every employer should therefore deduct the appropriate taxes before releasing the lump sum payment to the employee.

By Rhoda Wambui