On 6 April 2018, the tax treatment of termination payments is changing. Some previously exempt payments and benefits made on termination of an employment will become chargeable to income tax and National Insurance Contributions (NICs). Specifically, the changes will ensure that all payments in lieu of notice are subject to tax and do not benefit from the £30,000 exemption. In addition, the current foreign service relief will be abolished.
At present, payments on termination of employment, often referred to as payments in lieu of notice (‘PILON’s) may be exempt from tax up to £30,000 and exempt in their entirety from NICs. The tax treatment depends on whether the employer has the contractual right to terminate the employment by paying a PILON rather than allowing the employee to serve out their notice.
If the employer has a contractual right to terminate the employment by paying a PILON, the PILON is generally subject to income tax and NICs in full.
Where the employment contract is silent on the matter or does not allow the employer to terminate the employment by paying a PILON, and the employer does not allow the employee to work out their notice, the employer is in breach of the contract. Typically, this breach is remedied by making a payment to the employee. This is commonly referred to as a ‘non-contractual PILON’. As the payment is not contractual, it is not chargeable to income tax under the normal charging provisions for earnings. It is, however, caught by a final ‘catch all’ provision which subjects payments on termination of employment, which are not otherwise taxed, to tax to the extent they exceed £30,000 (note some payments are exempted completely).
These are the rules as they currently stand in broad terms, although there are exceptions and each case does require careful analysis of the terms of the contract and circumstances of any termination payment.
Rules from 6 April 2018
The new legislation applies to all payments, or benefits received on, or after, 6 April 2018 in respect of employments which end on, or after, 6 April 2018.
The new rules split termination benefits into two elements: post-employment notice pay (‘PENP’) and the remainder.
PENP is the amount of basic pay the employee will not receive because their employment was terminated without full, or proper notice being given. It is calculated by applying a formula set out in the legislation.
PENP is taxable as general earnings and so subject to income tax and NICs in full. The element of non-PENP (if not otherwise chargeable) can still benefit from the £30,000 exemption. For national insurance purposes, as from 6 April 2019, to the extent that the non PENP exceeds £30,000 it will be subject to Class 1A contributions (employer only).
Certain contractual payments which are already fully taxable (such as contractual PILONs) are deducted from the unworked notice pay figure. This means that only the balance is taxed, avoiding any double taxation.
The remainder of the termination payment can still benefit from the £30,000 tax exemption provided it is not otherwise chargeable.
PENP is calculated using the following formula:
((BP x D)/P) – T
BP = Basic Pay
P = duration of the last pay period
D = the duration of the post-employment notice period
T = any contractual PILON
Basic pay is defined as the ‘employment income of the employee from the employment’ in the pay period prior to the date on which notice is given, or, if no notice is given, the termination date. It excludes benefits, bonuses, commission, allowances, share options but, includes any amounts taken as salary sacrifice.
The duration of the post-employment notice period is the period from the employee’s actual termination date to the last day of the minimum notice, whether statutory or contractual.
An employee has a basic salary of £60,000 and a three month notice period. His employer enters into a settlement agreement with the employee whereby his employment is terminated with immediate effect. The employer pays £20,000.
If the employment terminates on 31 March 2018, it is likely that the payment can be made free of tax and national insurance, falling within the £30,000 exemption.
If the employment terminates on 30 April 2018, then the PENP needs to be calculated. The ‘BP’ is £5,000, ‘D’ the duration of the post-employment period is 92 days, ‘P’, the last pay period is 30 days. So the PENP is: £15,333 (£5,000 x 92/30). So £15,333 of the payment is subject to tax and national insurance (employee’s and employer’s) and the balance of £4,667, is free of tax and national insurance.
From 6 April 2018, employers will need to calculate the PENP for each employee whose employment is terminating. Paying a non-contractual PILON will cost both the employer and employee more.
Note the PENP does not need to be calculated for statutory redundancy payments.
Employers need to understand the effect of the new rules which increase the cost of making termination payments. Care is required in structuring payments, to ensure the correct amounts are subject to tax and national insurance.
For further information or to discuss specific cases, please call Vinnie Rome or Mark Wildi on 01689 877081, or complete our online form.