Currently, non-contractual compensation payments made solely on account of termination of an individual’s employment enjoy a favourable tax treatment in two respects – the payment can be made without deduction of income tax up to £30,000 and no employee or employer national insurance contributions (NICs) are payable on the termination payment. Payments eligible for this tax treatment are to be distinguished from payments paid pursuant to the individual’s employment contract, such as bonuses and contractual payments in lieu of notice, the full amount of which are subject to income tax and employer and employee NICs.
Having previously indicated its intention to simplify and make fairer the rules surrounding the taxation of termination payments, the Government has now published a new consultation setting out the conclusions of its earlier consultation in July 2015 as well as draft legislation to implement its proposed changes to the rules on termination payments located in the Income Tax (Earnings and Pensions) Act 2003. Subject to further comments from stakeholders on the new consultation (which is open for comment until 5 October 2016), the proposed changes to the relevant tax rules are due to take effect in April 2018.
Whilst the consultation considered increasing or decreasing the £30,000 tax exemption threshold on termination payments, the proposal is to preserve the existing threshold but to clarify the position in relation to NICs and payments referable to an employee’s notice period.
In summary, the proposals are as follows:
- All payments in lieu of notice (PILONs), whether contractual or discretionary, will be subject to income tax and both employee and employer NICs. This will simplify the current position (where contractual PILONs are subject to income tax and NICs but non-contractual PILONs are generally not). That said, the change may well increase the cost for employers of severance packages as NICs will be payable, regardless of whether the PILON is contractual or represents agreed damages for the notice period. For employers not to be able to apply the £30,000 exemption to severance payments in respect of what would have been the employee’s notice period will reduce employers’ ability to use the £30,000 exemption as part of an exit negotiation to make a severance package more attractive in net terms.
- All other payments which would have been treated as "general earnings" if the employee had worked the applicable notice period will also be subject to income tax and both employee and employer NICs – this will extend the tax charge to any bonuses and benefits provided in respect of what would have been the individual’s notice period.
- Non-contractual ex-gratia severance payments genuinely made in respect of the termination of the employee’s employment will continue to be exempt from income tax and both employee and employer NICs up to £30,000, provided they are not otherwise taxable for example as bonus or retirement payments. However, to the extent that such a payment exceeds £30,000, it will not only be taxable but will also be subject to employer NICs. There will, however, continue to be an unlimited exemption on such termination payments for employee NICs. At the current rate, this means that a severance package will attract an additional cost to the employer of 13.8% to the extent that an ex gratia payment exceeds £30,000. In the case of larger settlements, this could mean a substantial increase in the overall cost to the employer. This should be factored in when considering a proposed severance package.
- The exemption currently available from income tax and NICs in relation to a payment for disability or injury will only apply to impairments of a physical or psychological nature that affect the individual’s ability to perform their job properly. The Government proposes to clarify that this exemption will not extend to injury to feelings (which will fall within and count towards the £30,000 exemption). This will resolve some uncertainty in the existing case law.
- The Foreign Service Relief exemption, which exempts individuals have been working outside the UK for more than 75% of their time in the last 20 years, from paying income tax on termination payments on a proportionate basis, will be abolished over time on the basis that it is outdated.
- The tax exemptions currently applying in respect of payments to a registered pension scheme or payments in respect of certain legal costs incurred in relation to advice on the termination of an employee’s employment will remain in place.
Although the changes which are due to be implemented are not as substantial as they might have been, what is clear is that the costs which employers can incur in respect of the termination of employees’ employment is likely to increase. Employers will need to be consider a variety of issues under the proposed new regime including:
- The increased costs which the NIC changes will create.
- The proper tax treatment of payments they propose to make to departing employees.
- The clear structuring of severance agreements to reduce the risk of challenge from HMRC and provide, where appropriate, for tax indemnities.
- Whether the employer’s interests are better served by the individual employee spending the notice period on garden leave rather than being paid in lieu of notice once the tax consequences end up broadly the same.