HMRC has published its response to its 2015 consultation on simplifying the taxation of termination payments, together with draft legislation for further consultation until 5 October 2016. The consultation confirms the following changes will be made from April 2018:

  • All payments in respect of notice will be treated as earnings subject to income tax, employer NICs and employee NICs – it will no longer make any difference whether the payment is pursuant to a contractual obligation (or "pilon" clause), is an "auto-pilon" made automatically as a matter of course, or can properly be viewed as representing damages for breach of contract. Payments that are not compensation awards for unfair dismissal or redundancy payments will be treated as payments in respect of notice to the extent that they are equal to: (i) salary and the value of taxable benefits in kind for the period of notice not worked, using a rate averaged over the 12 weeks up to the giving of notice (or the end of employment if notice is not given), plus (ii) bonuses that the employee could reasonably have expected to receive had the notice period been worked and the employee remained in employment until the due payment date (even if this is after the date the notice would have expired). Pilon clauses are commonly included in contracts, particularly where the employer may wish to rely post-termination on restrictive covenants in the contract and therefore wants to be able to remove an employee swiftly without breaching the contract; this change will remove the tax disadvantage in including such a provision.
  • The exemption from income tax and employers' and employees NICs for payments relating to termination up to the current threshold of £30,000 will remain; proposals to introduce a variable threshold based on length of service or to limit it to redundancy payments have been dropped.
  • Employers' NICs will be payable on payments above £30,000 (to align the rules for income tax and employers' NICs).The foreign service exemption will be abolished, except in relation to seafarers.
  • Legislation will be amended to clarify that payments for injury to feelings in connection with termination will be taxable – the exemption for injury payments will only apply where there is a psychiatric injury or a recognised medical condition that is sufficient to cause the employee to be unable to perform their job properly (there is currently conflicting caselaw on this point).
  • The proposal to abolish the exemption for legal costs has been dropped.

The idea of simplifying the tax regime for termination payments is welcome, although there remains scope to improve the somewhat complex drafting dealing with the calculation of what is to be deemed notice pay. Further, the reduction in the scope for making notice or injury to feelings payments tax-free may have an adverse effect on negotiations with departing employees and, together with the additional NICs, increase the cost of terminations for employers. Employers may want to consider the impact of the changes vis-à-vis the timing of departures planned for Spring 2018.