Taxation of termination payments: New law in force April 2018
An important change is imminent to the tax treatment of employment termination payments
An important change is imminent to the tax treatment of employment termination payments, as part of the Government’s objective to ‘simplify and tighten’ the current regime.
From April 2018, all payments in lieu of notice (PILON) will be subject to income tax and employee Class 1 NICs regardless of whether there is a PILON clause in the contract of employment.
Currently, if the contract contains such a clause, any PILON will be subject to tax and Class 1 NICs. If not, the payment can be made free from tax and Class 1 NICs (up to a maximum of £30,000).
The change will be introduced by s5 Finance (No 2) Act 2017 and essentially splits termination payments into two elements.
The first element will be known as “post-employment notice pay” (PENP). This represents the amount of basic pay the employee will not receive because their employment was terminated without full or proper notice being given. This element will be subject to income tax and employee Class 1 NICs.
The legislation sets out a complex statutory formula to calculate the first element of the payment, which involves carrying out a number of preliminary calculations to establish the employee’s basic pay, the amount of the notice period outstanding following the termination date and the number of days in the employee’s last pay period. Once PENP has been calculated, any contractual PILON payment can be deducted, to give the final taxable sum.
Unfortunately, there is not yet any official HMRC guidance available on how to perform the calculations. It currently appears that the PENP will only take into account basic pay, and that bonus and commission payments need not be factored in. However it would be surprising if the Treasury intend to let these supplementary payments fall through the net. How exactly employers should treat sacrificed salary is also still unclear. It is promised that further details of how and when the PENP calculation should be applied will be published in the HMRC Employment Income Manual “in due course”.
The second element is the remaining balance of the termination payment. The balance of the payment is tax free up to £30,000 (provided that it represents income from employment). Any excess over £30,000 will be subject to income tax. Employees will continue to benefit from an unlimited NIC exemption for payments related to the termination of employment, so the whole of the balance of the payment will be free from Class 1 NICs.
Importantly, the new rules will not apply to statutory redundancy payments, which can still be made tax-free in their entirety. HMRC guidance had previously suggested that non-statutory redundancy payments would also be excluded from the new rules. However, this has now been amended and the reference to non-statutory payments removed.
What does this mean for me?
After a period of uncertainty regarding the implementation date of the measures, the Government has now clarified that the new rules will apply where both payment and termination occur on or after 6 April 2018. However, they may impact on termination agreements which you are considering or negotiating now.
While these changes do little to simplify the current regime for employers and employees they will certainly generate additional revenue for the Treasury by making many more termination payments subject to some element of tax.
They may make it more difficult to negotiate termination payments and may mean that you end up paying more to exit staff from your organisation. If an employee’s tax liability increases, it is likely that they will simply demand a higher total payment from their employer.
Additionally, from 6 April 2019 the cost of termination to employers will rise even further, when employer Class 1A NICs become payable on any element of a termination payment that exceeds £30,000. Employees will retain their unlimited employee NICs exemption in respect of termination payments (which do not relate to pay in lieu of notice).
If you don’t currently include a PILON clause in your contracts of employment you may now wish to consider doing so. In the past, many employers have chosen not to include a contractual right to pay in lieu of notice so that employees could benefit from the current tax exemption, and take the whole amount of any termination payment tax free. However, after April 2018, this advantage will be lost. Aside from the tax implications there may are other compelling commercial reasons to include a contractual PILON clause. For example, if an employer chooses to pay in lieu of notice when they have no contractual right to do so, they will technically be in breach of the employee’s contract. This makes it difficult to enforce other terms of the contract, such as restrictive covenants, against the employee.
Additionally, including a contractual right to pay in lieu of notice may mean that you don’t have to worry about carrying out the statutory calculation, if you are confident that the contractual sum will be greater. However, it may still be safest to adopt a ‘belt and braces’ attitude and perform the calculation in any event to ensure compliance. Remember to that you will still have the option of requiring an employee to work their notice, or placing them on garden leave for the duration of their notice period. We are happy to advise on the best approach and to help you run the numbers.
Louise Singh is a Professional Support Lawyer supporting the Employment Pensions and Immigration Team at Weightmans LLP and is based in Liverpool. Please do not hesitate to contact Louise or speak to your usual Weightmans advisor.
Please remember that Weightmans LLP is always able to provide specialist tax advice on employment related and other matters. If you have any questions or concerns please contact Haydn Rogan in our Corporate Commercial team who will be happy to advise you.