Following a review of the taxation of termination payments in July 2014, the Office for Tax Simplification concluded that the current rules around taxation of termination payments are complex and confusing. This resulted in the government launching a consultation in July 2015 on how termination payments are treated for the purposes of tax and National Insurance contributions (NICs). Its response to the consultation has now been published together with draft legislation designed to implement the changes it has decided to make. The exact wording of the draft legislation is open for consultation until 5 October 2016.

The proposals

The following changes are expected to take effect in April 2018:

  • The £30,000 income tax exemption for genuine termination payments will be retained and employees will continue to benefit from an unlimited employee NICs exemption;
  • Currently payments in lieu of notice (PILONs) are taxable if there is a clause in the employment contract which permits the making of such payments. If there is no such clause and no custom and practice of paying PILONs, the payment may be categorised as damages for breach of contract and therefore be paid free of tax and national insurance. The government has said that the current position is too complex and open for manipulation. To simplify this, all PILONs will now be subject to tax and national insurance as earnings;
  • Employers will be required to pay employer NICs on the part of any termination payment in excess of £30,000 (which is currently only subject to income tax); and
  • There are conflicting judicial decisions on the tax treatment of payments for injury to feelings (which is a remedy available in discrimination cases). The government has decided that payments of this kind will not benefit from any tax exemption so will be subject to deduction for income tax.

Although the legislation is currently only in draft form, it is likely that any changes made to the draft will not affect the substance of the above proposals.

Our view

It is good news for both employers and employees that the £30,000 tax emption is to be retained as it has long been a useful tool in negotiating the departure of employees. For employers it assists with managing the workforce effectively and employees benefit from a larger payment. For those termination payments over £30,000 however, employers will now have increased costs because they will have to pay employer NICs and will have to budget accordingly.

All PILONs being taxed has its pros and cons. On the one hand, there will no longer be any confusion over the tax position on PILONs. However, given that the PILON can no longer be paid tax free, employers will no longer be able to incentivise employees by offering merely a tax free PILON. To encourage settlement, it is likely that employers will have to pay an additional ex gratia amount on top of any PILON which will result in increased costs for employers.