Introduction

Her Majesty's Revenue and Customs (HMRC) has published guidance on the new rules that require income tax and national insurance contributions (NICs) to be paid on all payments in lieu of notice (PILONS) from April 6 2018.

The detailed guidance is contained in an updated version of the HMRC Employment Income Manual (paragraphs 13,874 to 13,898), together with a worked example.

While the guidance had been eagerly awaited, given the uncertainty over how the rules will operate in practice, a number of questions remain unanswered (for further details, please see "New tax rules for payments in lieu of notice"). In addition, HMRC's approach to allowances is likely to increase substantially the amount subject to income tax and NICs in situations where the employee receives standard allowances (eg, car allowance).

In light of the new guidance, this update provides an overview of:

• the new regime;
• how it will operate in practice; and
• some of the continuing areas of uncertainty.

New rules

Where an employee's employment terminates after April 5 2018 and he or she receives a payment after that date, the basic salary that the employee would have received for any period of unworked notice is subject to income tax and NICs in full. This is irrespective of whether the contact contains a PILON clause.

Under the new rules, if an employee is paid in lieu of some or all of his or her notice period, the employer must deduct income tax and employee NICs from, and pay employer NICs on, the employee's post-employment notice pay (PENP).

How is PENP calculated?

PENP is generally calculated using the formula ((BP x D)/P) - T, where:

• 'BP' is the basic pay in the pay period which ends before the date on which notice is given (if any) or, if no notice is given, the termination date (relevant pay period);
• 'D' is the number of calendar days in the post-employment notice period;
• 'P' is the number of calendar days in the relevant pay period; and
• 'T' is the contractual PILON.

A simplified formula can be used where:

• the employee is paid monthly;
• the minimum notice under the employment contract is a number of whole months; and
• the unworked notice period is a number of whole months.

In this situation, 'D' is the number of whole months in the post-employment notice period and 'P' is one day.

Basic pay excludes:

• benefits;
• bonuses;
• commission;
• allowances; and
• share options or awards.

However, if the employee participates in a salary sacrifice arrangement, the pre-sacrifice salary must be used for the calculation.

HMRC guidance states that an 'allowance' is a supplementary payment received by an employee over and above his or her standard pay; however, it does not include "any amount which is actually, or in reality reflects an amount which has been, consolidated into an employee's standard pay". This suggests that standard allowances such as car allowances or allowances in lieu of pension contributions should be included in the calculation of basic pay. This is likely to increase substantially the amount of PENP (in comparison to any contractual PILON) for employees in receipt of these types of allowance.

The 'post-employment notice period' is the period from the end of the day on which the employee's employment terminates to the earliest date on which the employer could have lawfully terminated the employment.

Fixed-term contracts

There are separate rules for fixed-term contracts where the contract does not include a requirement for notice to be given by either the employee or the employer. In broad terms, the basic pay that the employee would have received in the period beginning on the day after the employment terminated and ending on the date on which the limiting event occured is subject to income tax and NICs in full. The 'limiting event' is:

• the expiry of the fixed term;
• the performance of a specific task; or
• the occurrence of a specific event.

Termination payments

An employer must deduct PENP from the employee's relevant termination award. This is any payment or benefit which compensates the individual for the termination of his or her employment (ie, those payments and benefits which before April 6 2018 would have qualified for the £30,000 tax exemption), excluding any statutory redundancy pay.

PENP is subject to income tax and NICs in full.

Any statutory redundancy payment and the balance of the relevant termination award benefit from the £30,000 tax exemption and NICs exemption. If the relevant termination award is less than the PENP, the entire relevant termination award is subject to income tax and NICs.

Implications

The new rules have the following implications:

• If an employee works out his or her full notice or is put on garden leave for his or her full notice, the new rules do not apply.
• In situations where the new rules apply, the employer must ensure any settlement agreement clearly states that it will deduct income tax and employee NICs from PENP.
• Employers must calculate the PENP for each employee whose employment is terminating, including those employees whose employment contracts contain a PILON clause. Employees will likely want to see this calculation before signing any settlement agreement.
• If the PILON is contractual, there are two limited scenarios where the PENP is likely to be zero. This depends on how the contractual PILON is calculated and must still be checked in every case.

Scenario 1 The PENP is likely to be zero if:

• there is a contractual PILON based on a number of whole months;
• there is no salary sacrifice arrangement in place (or PILON is calculated on the basis of pre-salary sacrifice salary);
• no standard cash allowances are paid (or PILON is calculated taking those allowances into account); and
• the unworked notice period is in a number of whole months.

Scenario 2 The PENP is likely to be zero if:

• there is a contractual PILON based on a number of weeks;
• there is no salary sacrifice arrangement in place (or PILON is calculated on the basis of pre-salary sacrifice salary);
• no standard cash allowances are paid (or PILON is calculated taking those allowances into account); and
• the relevant pay period is 31 days.

From April 6 2018, there is no tax disadvantage in having a PILON clause for basic salary in the contract.

Areas of uncertainty

It is uncertain how the new rules will apply in a number of situations and employers should seek specific advice regarding the following:

• The first uncertainty concerns the anti-avoidance provisions which allow HMRC to ignore any arrangements that are designed to reduce PENP. It is unclear how these apply where the employee asks for some or all of the relevant termination award to be paid into his or her pension. Pension contributions would normally fall outside the scope of the new rules; however, it is possible that HMRC would view a request for a pension contribution as an arrangement to reduce PENP. Therefore, it may seek tax and NICs on the relevant termination award as if the pension contribution has not been made.
• It is unclear how the new rules apply where the employee has received no pay in the relevant pay period (eg, because he or she exhausted his or her entitlement to both company and statutory sick pay). Presumably, basic pay and therefore PENP would be nil in these circumstances and the new rules would not apply.
• If an employee's employment is terminated summarily without notice or pay in lieu of notice, it is unclear whether it is necessary to apply the PENP calculation to any relevant termination award that the employee receives. The more cautious approach is for employers to calculate PENP and apply tax and NICs to it.
• In some cases, the employee's notice period may be less than the employer's notice period. However, PENP is calculated on the basis of the employer's notice period. As a result, if the employee resigns and receives a relevant termination award, the PENP must be calculated based on the notice period that would have been required from the employer (rather than the shorter notice actually given by the employee).

Further guidance on the practical operation of these new rules would be helpful for employers grappling with their implementation, particularly given the areas of continuing uncertainty, but HMRC has given no indication that further guidance will be forthcoming.

For further information on this topic please contact Victoria Goode at Lewis Silkin by telephone (+44 20 7074 8000?) or email (victoria.goode@lewissilkin.com). The Lewis Silkin website can be accessed at www.lewissilkin.com.

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