The taxation of termination payments has significantly changed with effect from this April; changes intended by the Government to “clarify and tighten” the previous rules. Going forward, payments in lieu of notice (‘PILONs’) can no longer be paid free of tax, regardless of whether or not there is a contractual PILON clause in an employee’s contract.
Until now, certain termination payments were treated as taxable as earnings through PAYE; some as a payment for a restrictive covenant, and some falling within the specific rules dealing with termination payments. The specific rules were already broadly drafted, catching most ex gratia payments, subject to certain exemptions. The most commonly relied-upon exemption in practice applied to the first £30,000 of payments made in relation to the termination of employment, provided the employee’s contract did not include a PILON clause (which would otherwise render notice pay taxable).
Going forward, however, all PILONs will be subject to PAYE deductions regardless of whether there is a PILON clause. Employers will be required to tax an amount paid to their departing employee equivalent to their notice pay, if the employee has not worked their period of notice. The £30,000 exemption still applies to statutory redundancy pay and approved contractual redundancy pay, as well as to payments or benefits otherwise chargeable to tax. Any other non-statutory redundancy pay, however, will no longer automatically fall within the £30,000 exemption.
To work out the tax treatment, employers will need to apply a formula to calculate ‘Post-Employment Notice Pay’ (PENP), which is essentially the amount that would be paid to the employee as normal pay for the whole of their notice period, if they were working it. If the PENP amount is greater than or equal to the ‘relevant termination award’ (the amount of a termination award which is not a redundancy payment), the whole of the ‘relevant termination award’ is treated as earnings from the employment. If the ‘relevant termination award’ exceeds the PENP, only the PENP amount is treated as earnings from employment.
All amounts treated as earnings will be subject to class 1 NICs (employee and employer). It will continue to be the case that no employee NICs are payable on ex gratia elements of termination payments, but note that from April 2019, employer’s NICs will be payable on the amount of the ex gratia termination payment which is subject to income tax.
HMRC has confirmed that the payment in lieu of notice tax changes have effect only for payments made in, and relating to termination occurring in, the 2018-19 tax year and subsequent years. This means that it applies only to terminations on or after 6 April 2018.
Other significant changes to the taxation rules, also with effect from April 2018 are:
- The injury exemption will still exempt psychiatric injury but will no longer include injury to feelings awards.
- The foreign service exemption is abolished.
- The Treasury will have the power to vary the £30,000 threshold.