The government has unveiled its draft legislation, setting out how it plans to simplify and tighten the rules on the taxation of termination payments.
In the government's March 2016 Budget, it announced its proposals as to how it was going address the taxation of termination payments. The proposals followed a consultation launched in 2015. The government has now published its response to that consultation as well as the draft legislation to deliver the proposed changes. The draft regulations will result in increased costs for employers, although the new regime will be somewhat less confusing that the current regime. Overall, employers will be pleased that the £30,000 tax free threshold on termination payments will remain and that the Government has dropped its proposals to have a lower, variable threshold.
The changes are expected to come into force in April 2018 after another period of public consultation on the draft legislation, which will close on 5 October 2016.
The current rules
A payment made on termination of employment is often made up of several different elements which may include, for example, a statutory redundancy payment, any enhanced payment, a payment in lieu of notice (PILON) and an ex gratia payment to cover any potential claims. Currently PILON payments that are either provided for in the contract of employment, or which are paid "automatically" on the termination of employment, are fully taxable, whilst other elements, such as compensation for breach of contract, ex gratia payments, and redundancy payments are tax free up to an aggregate amount of £30,000 (once over that amount such payments are subject to income tax, but remain free of NICs.
A report by the Office of Tax Simplification in 2014 found that there is confusion around these rules (which it called "complex") – although the reality is that they are well understood by HR departments.
The Government's new draft regulations
Following an initial public consultation which closed in October 2015, the Government has published new draft regulations providing that -
- The first £30,000 of a termination payment will remain exempt from income tax and employer and employee NICs
Clyde & Co comment– employers will welcome the fact that there is to be no reduction in the current £30,000 threshold. However, as will be seen below, payments which fall to be classified as "termination payments" are narrower in scope.
- Termination payments over £30,000 will continue to be subject to income tax, but will now also be subject to employer NICs (but not employee NICs)
Clyde & Co comment- this was first announced in the March 2016 budget. It always seemed odd that although income tax became payable on amounts over £30,000, national insurance contributions did not. Unfortunately this change will lead to an increased cost for employers, with employers' NICs being at 13.8%, but we can't see this having a huge impact on the number of settlements because the very important tax break for the employee (the first £30,000) will remain - and that is to be welcomed.
- Redundancy payments, ex-gratia compensation payments and unfair dismissal awards will continue to count as termination payments and so will be taxable only to the extent they exceed £30,000
- However, the current distinction between contractual and non-contractual PILONs will be removed so that all payments which are paid in lieu of notice will be fully taxable. It is proposed that any amount received as pay in lieu of notice (PILON) and any other payment (including benefits in kind) that the employee receives, or would have received during their notice period (whether or not they work for it) will be fully taxable as general earnings, and subject to employer and employee NICs
Clyde & Co comment – Currently, a PILON which is paid under the terms of an employment contract is fully taxable, whereas the £30,000 exemption can be used for damages paid in lieu of a notice period if the contract has no PILON clause and the employer doesn't pay the amount "automatically". This strange differential has now been removed, so all amounts paid in relation to a notice period will be taxable.
- Foreign service relief will be removed except in relation to seafarers
- The new rules will clarify that amounts paid in relation to injury to feelings (which is an area which has been historically used to pay damages tax free in discrimination cases) will no longer be tax free – unless there is either psychiatric injury or another recognised medical condition which has resulted from the treatment in question
Clyde & Co comment- The foreign service relief is little used so this change should have minimal impact for most employers. As regards the exemption for injury to feelings, this is a closing of the door on an area which has led to tax free amounts being paid in the past, in cases where there has been no actual "personal injury" (by which we mean recognised medical condition suffered).