On 6 April 2018, the rules regarding the taxation of some termination payments changed. Here we look at the new rules and the potential impact that they could have on future termination payments and employment contracts.

All Change?

The new regime applies to all payments in lieu of notice (PILON) paid on termination of employment. Whereas previously it was usually the case that if you did not have a PILON in the contract, you would not have to tax monies paid in lieu of notice (up to the 30,000 cap). Under the new rules, the intention is to tax (and subject to class 1 NICs) as earnings the basic pay an employee would have earned if the employee had worked his or her notice in full.

The New Rules

After some initial confusion, the government has now clarified that the new taxation rules only apply where both the termination and payment take place on or after 6 April 2018. Tax will be payable on the basic pay that an employee should have received during the remainder of their notice period. This basic pay figure should include the value of any salary sacrifice amounts but sums excluded from basic pay, such as over-time, commission, bonuses and benefits in kind should not be included. In order to calculate the amount of pay taxable, one of two calculations set out in the legislation will need to be performed. The calculation required depends on whether or not the following are expressed in months or days in the contract of employment:

1) the regularity with which the employee is paid;

2) the length of the notice period required to be given by the employer (by law or in the contract); and

3) the amount of unworked notice.

If an employee is paid monthly, and both the notice period and unworked notice period are expressed as whole months, then the calculation can be done using monthly pay. If not, basic pay must be calculated using a daily rate averaged over the last pay period worked, which will be more complicated and will be affected by the number of days in the month preceding the termination.

Effect: Include a PILON Clause

It will now almost always make sense to include a PILON in your contracts, since that will mean that where you are only paying notice on termination, you will not need to carry out the calculation above. However, employers should note that where they are paying notice plus an ex gratia sum the calculation above must be carried out since using the statutory formula could result in a slightly different amount to be taxed.