The government has set out its proposals on the taxation of termination payments from April 2018. What is changing?
The position now
Not all sums payable under a settlement agreement are tax-free. Employers need to break down the different elements of a package and consider whether each part is taxable.
PILONs (payments in lieu of notice)
Currently, if you have a contractual right to make a PILON, that payment is subject to tax and NICs.
If you don’t have a contractual right to make a PILON, any payment made in respect of an employee’s notice entitlement is generally regarded as ‘damages for breach of contract’ and the first £30,000 can be paid tax-free (and no NICs are due).
From April 2018, all PILONs will be taxable and subject to NICs.
Other contractual payments – benefits and bonuses
At present, payments due under an employee’s contract should be subject to tax and NICs. But:
- Some employers deliberately breach an employee’s contract by giving insufficient notice, when there is no PILON clause. This allows payments made in place of benefits / bonuses (that would have been due if the employee had worked their notice) to be covered by the £30,000 exemption.
- Even if there is no breach of contract (because there is a PILON clause or an employee agrees not to work their notice) some employers make ‘ex gratia’ termination payments that include sums to cover benefits / bonuses that would have been due if the employee had worked their notice – taking the view (possibly wrongly) that these fall within the £30,000 exemption.
- If an employer is paying in lieu of notice under a PILON clause which only requires payment of basic salary, any sums paid to the employee in their settlement package to compensate for benefits / bonuses that would have been due if the employee had worked their notice are covered by the £30,000 exemption.
The government has concerns about these issues and, in terms of taxation, wants to treat all employees as having worked their notice regardless of what actually happens.
So, from April 2018, the following will be subject to tax and NICs:
- Post-employment notice income: If an employee doesn’t work their notice (for whatever reason) they will still need to pay tax and NICs on any payment which corresponds to the earnings they would have received if they had worked their notice. These earnings will be calculated on the basis of their actual earnings in the previous 12 weeks. This will include compensation for loss of taxable benefits (even if there was no PILON clause or it provided for basic salary only).
- Expected bonus income: This includes any bonus that the employee would have received (if their employment had continued long enough) during their notice, or at another time but which relates to the time before their employment ended or the time that would have been their notice period. ‘Bonus’ includes commission, incentives or anything similar.
Tribunal awards for unfair dismissal, redundancy payments and contractual payments in lieu of redundancy will continue to benefit from the £30,000 exemption.
The proposals are intended to simplify the taxation of termination payments, but the complex draft legislation may have the opposite effect in some cases. The proposals also mean that some payments that currently fall into the £30,000 exemption will be subject to tax and NICs.
£30,000 exemption and employer NICs
For now, the first £30,000 of a non-contractual termination payment is tax free, with any balance over £30,000 subject to tax. No employee or employer NICs are due.
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.
From April 2018, however, employer NICs will be due on any balance over £30,000. This will align tax and employer NICs, but will increase the cost of termination payments for employers.
There will be no change as regards employee NICs.
Payments for injury to feelings – discrimination
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.
Note that injury to feelings payments where the discrimination is not related to termination can be paid tax-free – this is not changing.
Payment in respect of certain legal costs
Payments from employers to employees’ solicitors in connection with legal advice relating to settlement agreements are exempt from income tax and NICs. The government consulted on removing this exemption, but has decided to retain it.
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.
This exemption will be removed from April 2018, but those who have worked abroad can still take advantage of the usual £30,000 exemption.
The government is consulting on the draft legislation with responses due by 5 October. We’ll update you if there are any changes to the details above.