Following the government's consultation on termination payments last summer and its statement in the 2016 Budget, HMRC has published another consultation on changes to the way termination payments are taxed. The proposed new rules would apply to termination payments from April 2018. Whilst the stated aim of the changes is to simplify the system, the draft legislation published by HMRC suggests the opposite.
At present, on termination of employment certain payments may be paid free of tax and National Insurance Contributions (both employer and employee) up to a maximum of £30,000, with the excess over £30,000 being subject to tax but not National Insurance Contributions.
The Government has been considering changes to this tax provision for some time, and has previously suggested that the £30,000 limit might be changed. It has now published its proposals, which are intended to take effect from April 2018. The current tax free amount of £30,000 is retained (though the new rules make it clear that this amount could be changed by regulation). However, there are a number of further changes proposed in the legislation, some of which are surprisingly complex.
The Government proposes that, from April 2018:
- Employer (but not employee) NICs will be due on termination payments above £30,000
- All payments in lieu of notice (PILONs) will be subject to income tax and NICs, regardless of whether there is a PILON clause in the contract
- Any payments that an employee would have received in respect of their notice period had they worked their notice period will also be subject to income tax and NICs
- The existing complete tax exemption for payments made on account of injury to an employee will not apply to payments for injury to feelings unless that injury amounts to a psychiatric injury or other recognised medical condition
- The full or partial tax exemption for termination payments paid to employees who have spent part of their employment abroad ("Foreign Service Relief") will be removed
Arguably the most significant of these proposals is that relating to notice pay. At the moment, payments in lieu of notice are taxable where there is a PILON clause in the contract, or where the employer has an automatic practice of paying in lieu of notice (so-called "auto-PILONs"). However, where there is no PILON clause, and the employer genuinely turns its mind to whether to pay in lieu of notice or require the employee to work some or all of the notice period, in principle such payments in lieu can be paid free of tax up to a maximum of £30,000.
The Government has decided that it wishes to remove the distinction between situations where there is a PILON clause and where there is none. In principle, that is a simple proposal. However, the draft legislation it has put forward to implement this change is potentially highly complex. It involves taxing not the amount that the employee is paid in respect of their notice period, but an amount they would have been paid if they had worked their notice period, calculated by averaging the employee's earnings (other than bonuses and commission) in respect of the 12 weeks immediately prior to the termination of employment.
The 12-week averaging could produce unexpected results. If, for example, the employee worked an unusual amount of overtime immediately prior to the termination date, the result will be that the employer will be obliged to tax a greater proportion of the termination payment than would have been the case if the employee had actually worked his notice period and carried out the normal, lower level of overtime.
Second, the 12-week averaging is not just intended for non-contractual payments where there is no PILON clause. It applies even where a payment is made under a contractual PILON clause. This means that a portion of the termination payment will be taxed as notice pay where the contractual PILON is less than the employee's average earnings, for example where the PILON is based on basic pay only but the employee received additional payments such as overtime or shift pay during the 12 weeks preceding the termination of employment.
The draft legislation makes another very significant amendment to the treatment of termination payments where a bonus scheme exists but, somewhat curiously, little mention is made of the reasons for this in the consultation paper.
The provisions on bonuses are extremely difficult to understand. In summary, whenever an employer seeks to make a termination payment attracting the beneficial tax treatment of the first £30,000 referred to above where there is a bonus scheme in place, there is some risk that it will have to tax a portion of the termination payment to account for the bonus that the employee would have received in respect of the period of active employment and the period up to the end of the notice period if he/she had remained in employment long enough to receive it. For these purposes, it appears that any term of the bonus scheme which states that the payment of a bonus is conditional on being employed on the payment date is effectively disregarded.
This is perhaps best illustrated by reference to an example.
Bonus - Worked Example
Take, for example, a bonus scheme under which the bonus for each calendar year is paid in March of the following year. It is condition of receiving the bonus that the employee is still employed and not under notice of termination at the time of payment.
If the employee leaves in February 2017 and is paid in lieu of his/her notice period, it is clear that he/she will not be entitled to a bonus under the 2016 bonus scheme, because he/she has not yet reached the payment date for the 2016 bonus year when employment terminates. Let's also assume that the employee was paid in lieu of notice pursuant to a PILON clause (so that the payment is taxable and subject to NICs in full), and the employer decides to make a termination payment of £10,000, which is partly to compensate for the fact that the employee hasn’t received the 2016 bonus.
Under the current rules, the entire £10,000 will be payable free of tax and free of NICs, since it falls well under the £30,000 threshold. However, if the Government's draft legislation is implemented as it presently stands, the employer will first have to undertake two calculations before determining the correct tax treatment of that payment, as follows:
- Assuming the employee was still employed and not under notice in March 2017 (when the 2016 bonus would have been paid), what bonus could he/she have reasonably expected to receive for the 2016 calendar year? Let's assume that this figure is £2,000.
- Assuming that the employee was still employed and not under notice in March 2018 (when the 2017 bonus would have been paid), what bonus could he/she have reasonably expected to receive in respect of that part of the 2017 calendar year he/she would have worked if he/she had worked the whole period of notice? Let's assume that this figure is £500.
The net result will be that £2,500 (i.e. the sum of 1 and 2) of the £10,000 termination payment will be subject to tax and National Insurance contributions (employer and employee) in full, leaving only £7,500 to be paid free of tax and National Insurance.
Application of Bonus Provisions
The circumstances in which this provision will apply are far from clear. The draft legislation states that it only applies to payments "by way of bonus". This might suggest that it only applies if the employer expressly intends that part of the termination payment should reflect bonus. However, it seems unlikely that HMRC intended that this provision should only apply where such an intention is stated, since well-advised employers would simply opt not to mention bonus, so as to avoid the application of the provision (so, in the example above, the employer would simply confirm that none of the £10,000 payment was intended to compensate for bonus). If, in the alternative, HMRC will expect employers to actively consider whether any part of the termination payment should be deemed to be in respect of bonus, even if that was not the employer's intention, the result will be huge complexity for employers, and a great many termination payments are likely to become taxable in part when they otherwise would not be.
The Government's consultation on this draft legislation is open until 5 October 2016 and we propose to submit a response to it highlighting our concerns about this draft legislation.