What is changing: at a glance
The following changes will apply to payments or benefits received by an employee on or after 6 April 2018 in circumstances where their employment is also ended on or after 6 April 2018.
- Non-contractual payments in lieu of notice (PILONs) will be taxable as earnings and subject to Class 1 NIC in the same way as contractual PILONs currently are;
- Foreign service exemption and partial relief will be abolished for UK tax resident employees in the tax year in which the employment terminates;
- The exemption from tax on injury payments will no longer apply, except where there is a recognised psychiatric injury or other medical
These changes may affect the expected cost to the employer of terminating an employee and should therefore be considered in plenty of time in advance of a termination to plan accordingly.
There may also be an opportunity to effectively sacrifice termination payments into pension if there is surplus termination pay which will not be needed to fund regular outgoings over a non- working period.
Non–contractual payments in lieu of notice
Currently, where an employee’s contract of employment is terminated in circumstances where they do not work out their notice and notice period monies are paid in accordance with a pay in lieu of notice (PILON) clause in the contract of employment; income tax and national insurance contributions (NIC) will be deducted from the sum.
If there is no contractual right to make a PILON, any notice period monies paid are often treated as damages for breach of contract, up to the first £30,000 of which can be paid tax free (and no NIC is due). This will no longer be the position as of 6 April 2018.
The changes will apply to payments or benefits received on or after 6 April 2018 in circumstances where the employment is also ended on or after 6 April 2018.
From 6 April this year income tax and NIC must be paid on all payments in lieu of notice as they will be treated as earnings. There will no longer be a potential distinction between the tax treatment of notice payments made under or in the absence of a PILON clause in an employment contract. Instead, to the extent that notice is not worked, employers will be required to subject to tax and NIC an amount equivalent to the employee’s basic pay for a deemed notice period-. Where a termination payment which is not a statutory redundancy payment (“RTA”) is paid to an employee the employer will need to calculate how much of it is “post-employment notice pay” (“PENP”). PENP is calculated as the basic pay the employee would have received during any unworked period of notice less any contractual PILON and is subject to income tax and NIC in full.
‘Basic pay’ means the employee’s pre-salary sacrifice pay in the pay period immediately prior to the date on which notice is given (or if no notice given, on the termination date). Basic pay does not include overtime, bonus, commission, allowances, share and share option gains and benefits in kind.
How the calculation should be carried out is set out in the legislation. Essentially this involves identifying the different elements of the settlement agreement package and identifying how much of it is taxable.
Step 1: identify the different elements of the termination package (this is not a new step. This breakdown should always be carried out to determine how to treat for tax purposes the components of the termination package).
Step 2: identify Relevant Termination Award (RTA).
Step 3: calculate Post-employment notice pay (PENP).
Step 4: compare RTA and PENP
If PENP is greater than or equal to the RTA: the total RTA is treated as earnings.
If PENP is less than the RTA but is not nil: that part of the RTA is treated as earnings.
Step 5: the output is treated and taxed as earnings and subject to income tax and class 1 NIC through PAYE in the usual way.
Foreign service relief
Currently, termination payments to UK resident employees can be exempt (in whole or in part) if they relate to periods spent working outside of the UK by applying Foreign Service Relief (FSR). FSR will be abolished for employees (other than seafarers) who are neatax resident in the UK in the tax year in which their employment terminates, and whose employment terminates on or after 6 April 2018. However, such employees can still take advantage of the usual £30,000 exemption.
Injury to feelings taxation
There has been confusion as to whether termination payments relating to ‘injury to feelings’ are exempt from tax (under an exemption for payments relating to disability or injury). From April 2018, the government has clarified that payments for injury to feelings will only be exempt if they relate to a psychiatric injury or other recognised medical condition. Injury to feelings payments where the discrimination is not related to termination can currently be paid tax-free and this position will remain the same.
…and what remains the same
- Payments directly into pension schemes which fall outside the termination payments rules will be
- Statutory redundancy payments (to the extent that they are under £30,000) will automatically fall into the exemption
When entering into settlement negotiations it is always important to check the terms of an employment contract. If there is no contractual PILON and the termination date of employment falls on or after 6 April 2018, the new rules will apply and terminations may cost the employer (and potentially the employee) more. The employer will need to pay employer NIC of 13.8% on the PENP and the employee will have to pay income tax and employee NIC on the PENP.
As salary sacrifice arrangements are ignored for the purposes of calculating the PENP paying a PILON under such an arrangement may present an additional cost to both parties as the PENP figure which is compared to the RTA in step 4 above is increased.
Whilst the changes appear conceptually simple, there will be devil in the detail of working through the effects of the calculation.
Termination payments may continue to be sacrificed in exchange for pension contributions subject to the usual rules and caps on the amount that can be sacrificed tax-efficiently. If affordable to the employee, this may be an opportunity which employees and employers further consider at termination.
From April 2019 any termination payment in excess of £30,000 will be subject to both income tax and employer Class 1A NIC. This will align tax and employer NIC, but will increase the cost of termination payments for employers. Currently there is no employee NIC due and there will be no change as regards employee NIC. The government has opted to retain the £30,000 limit (originally set in 1988) and has no plans to increase it in line with inflation.
It is acknowledged that the new rules coming into force this April are somewhat complex and HMRC is due to issue guidance on how the new rules operate in practice “soon”. However the government, in its House of Commons taxation of termination payments briefing paper published last autumn, estimates that the forthcoming changes will raise just over £400m a year from 2018/19 from the increased tax and NIC due on termination payments.