The Government has confirmed this week that the £30,000 tax free allowance on certain elements of termination payments is to be retained –but not necessarily as we know it.
In the Summer budget of 2015, the Government revealed an intention to review the tax and National Insurance contributions (NIC) treatment of termination payments arising on the ending of employment, to make the system “simpler and fairer”.
The Government has now clarified what “simplification” will mean in a Response to Consultation published this week. Despite speculation that the current £30,000 tax free allowance on certain elements of termination payments might be scrapped, the Government has confirmed its plans to keep it after all. However, from April 2018, certain payments will no longer fall within this allowance, a development which could nonetheless signal significant change to current practice for employers and also the financial expectations of employees, on leaving.
Key Government proposals from April 2018 are that:
- all payments in lieu of notice (both contractual and discretionary) will be taxable earnings and subject to tax and national insurance contributions (NIC);
- all other post-employment payments which would have been subject to tax and NIC had an employee worked their notice will be similarly treated as taxable earnings (removing the opportunity to argue such payments are damages for breach of contract and should be included in the allowance);
- Rules for income tax and employer NICs will be aligned, so that payments over £30,000 will attract NIC;
- Subject to the above, termination payments which are non-contractual will be tax and NIC exempt up to the amount of £30,000.
Calls for Simplification
At the end of employment, various payments may fall due to the departing individual. The majority of payments are likely to form part of the employer’s contractual liability and, as such, will be subject to income tax and to NIC in the same way as salary. However, the current position on tax for other elements of termination payments is arguably less clear due to the wording of the legislation (the Income Tax (Earnings and Pension) Act 2003 or “ITEPA”) and case law that has arisen around it.
Historically, issues such as ex-gratia payments have presented areas of particular confusion. Section 401 of ITEPA applies to employment-related payments and benefits which do not constitute “general earnings” or “specific employment income” and accordingly are not automatically subject to tax. These payments may be tax exempt up to the first £30,000. There are other exemptions, reliefs and reductions which could also apply. Importantly, NIC are required only in respect of payments which are derived from employment, therefore these other payments would not attract NIC.
In 2014, the Office of Tax Simplification (OTS) issued a final report on termination payments and concluded that the current system is fraught with confusion and uncertainty. It found, for example, that many employers misunderstand the application of the £30,000 tax-exemption, and many employees believe that it will apply to any “pay-off”. Payments in lieu of notice are particularly problematic, along with payments on retirement.
The OTS report made several recommendations with the aim of creating a regime that is easier for employers to administer and for employees to understand, including the following:
- Consultation over reform of the current system;
- Better-alignment of the tax and NIC treatment of termination payments;
- Removing the distinction between contractual and non-contractual termination payments; and
- Replacing the £30,000 exemption with either a blanket exemption or an exemption applicable to statutory redundancy payments only.
A Government consultation followed in July 2015, floating various suggestions for reform, including those of the OTS but also allowing opportunity for stakeholders to comment more generally. The Response to that consultation published this week discloses those steps the Government intends to pursue in order to remedy many of the problems identified.
Having concluded that the £30,000 tax free element of termination payments should be retained, the Government was left with limited options to achieve the required clarity over which payments fall within that allowance. Even so, proposals will be brought into effect through changes to the ITEPA, the wording of which is now the subject of further consultation.
- Removal of the distinction between contractual and discretionary PILONS
Faced with an option of removing the distinction between all contractual and non-contractual termination payments, not just PILONS, the Government concluded that, viewed overall, the distinction continues to be supportable and rejected suggestions that it causes confusion. In contrast, accommodating the OTS suggestion to treat both contractual and non-contractual payments the same, would give rise to a new raft of rules and complexities. As a result, what is proposed is a tightening of the application of the allowance to certain non-contractual elements of termination pay.
The tax treatment of PILONS has long been a bugbear of HMRC and one of the greatest areas of confusion for employers and employees. As a result, under the revised provisions, all such payments will be treated as taxable earnings and there will no longer be an opportunity to argue that a discretionary payment, made in the absence of contractual obligation, falls within the allowance. Employer-debate over whether or not to have contractual clauses regarding PILONS will largely become a thing of the past.
- Curbing manipulation through post-termination “damages” payments
The new provisions also aim to curb the not uncommon practice of prematurely terminating employment in breach of contract, so as to claim the allowance in respect of consequential payment of damages to the employee. Going forwards, any payment the employee would have received had they been permitted to work their notice in accordance with their contract, will be taxed and subject to NIC in the usual way. This would include,
- Aligning income tax and NIC rules
Under current provisions, income tax is charged on termination payments exceeding £30,000 but employer NIC are not, an anomaly highlighted by OTS. Whilst some respondents to the consultation were fearful that adding employer NIC to all payments subject to tax would impose increased financial burden for employers, in the spirit of simplifying the rules, the Government plans to align the respective rules. The employee NIC exemption on termination payments will not be changed.
- Changes to current exemptions
In line with strong representations from respondents to the consultation, the Government will maintain the majority of existing tax-exempted payments, such as those arising because of the death, disability or injury of the employee.
However, in respect of exempted payments related to disability or injury, the Government has confirmed this will no longer include payments for injury to feelings. Changes will be made to ensure the exemption applies only to payments in respect of injury or disability of a physical or psychological nature which prevents an individual from carrying out their employment.
An additional change will be that Foreign Service Relief, which is perceived as outdated, will be removed in due course.
The above changes are due to take effect from April, 2018.
The proposed streamlining of practice, although less radical than many had expected, will provide increased certainty over applicable deductions from termination payments but will inevitably change the way in which termination payments are looked at . Once the changes take effect, it seems likely that tax liability will rise in many cases and many employees will receive lower than expected payments, leading to disappointment and likely adverse impact upon the negotiating position of the employer in settlement discussions. Employers may therefore wish to take steps to not only prepare financially but also communicate the changes in advance.
It also remains to be seen whether, during the intervening months before the introduction of these changes, some employee departures’ will be hastened, to allow for argument that the £30,000 exemption should apply before such opportunity is lost.
Employers may also wish to be aware that HMRC has itself launched a Consultation on proposals to limit the range of benefits in kind that attract income tax and National Insurance contributions advantages when they are provided as part of salary sacrifice and flexible benefit arrangements.