The UK Government is altering the tax treatment of some termination payments for exits taking effect on or after 6 April. These changes are the product of the HMRC’s grotesquely misnamed Simplification of the Tax and NI Treatment of Termination Payments consultation paper in August 2015. The worst excesses of this have come off in the wash since then, but it remains the case that the only simplification here is that the Treasury simply gets more money.

The changes fall under three heads:

(a) Foreign service relief (where tax on compensation is reduced to reflect overseas periods of employment) will be abolished. Currently foreign service relief allows termination payments for certain qualifying individuals to be completely exempt from income tax.

(b) The exemption from tax for payments for injury and disability will not apply to injury to feelings, whether on or before termination of employment, except where the injury amounts to a psychiatric injury or other recognised medical condition.

(c) All payments in lieu of notice will be treated as earnings and therefore subject to tax and class 1 NICs. This is irrespective of whether there is a PILON clause in the contract of employment. Here’s an example:

Ruth has a monthly basic salary of £5,000, a three-month notice period and no PILON clause in her contract of employment. Her employer decides to dismiss Ruth without notice and the parties agree on a termination payment of £30,000, the equivalent of six months’ salary.

Under the current rules, the employer could pay the full £30,000 tax-free because there is no PILON clause. Under the new rules, the employer would instead be required to work out Ruth’s “post-employment notice pay” to determine the amount of the termination payment that is subject to tax and NICs. Wearing the simplification objective only lightly, the new legislation contains a formula for doing this:

where BP = the employee’s basic pay for the last pay period (week or month) before the date on which notice is given. For the purposes of the calculation, basic pay excludes overtime, bonuses, commissions, allowances, benefits in kind, etc., but that does not mean that you no longer have to include them in your severance calculations;

D = the number of days in the “post-employment notice period” (the period from the last day of employment to the date when the notice period would have expired if given in full);

P = the number of days in the last pay period; and

T = amounts paid on termination (other than holiday pay and termination bonuses) that are already taxable as earnings (e.g. a contractual PILON).

Things are slightly simpler if, as in Ruth’s scenario, the employee gets paid monthly and the notice period and the “post-employment notice period” are both expressed in months. In those circumstances the new rules say that D = the length of the notice period in months and P = one. In all other cases, however, the reference to “number of days” does unfortunately mean that the exact figure will depend on the month in which notice is given and we are left with the proposition that the taxable part of a severance payment will be greatest for dismissals in March because the preceding pay period has the smallest number of days. Did no one in HMRC think about just how silly that sounds? What next? Phases of the moon? Quite why the rules could not have referred just to “basic pay for the unserved part of the notice period” is hard to understand.

If we apply the formula then Ruth’s post-employment notice pay is £15,000 (1 month’s pay @ £5,000 x 3 months’ notice ÷ 1 month pay period). This amount will be treated as earnings (and thus fully taxable and NIC-able).

The remaining £15,000 is subject to the “normal” rules on termination payments (including the £30,000 exemption) and taxed (or here not) accordingly. As the balance of the payment falls within the £30,000 exemption, it should be free from income tax and NICs. So Ruth is worse off under the new rules by about 40% of £15,000 because she has to pay tax on the “notice” £15,000 which she could previously have had tax free. The employer is also prejudiced because it now has to pay NICs on the notice pay where before it did not.

The only winner from any of this is the Treasury. The reality of course is that it will often be the employer which is the loser and carries most or all that extra cost, not the employee. Most termination payments are negotiated by reference to the net benefit to the employee, so if I lose out because of any of these changes, I am simply going to up my demands of my (ex-) employer to compensate. After all, I still suffer the same net losses from my dismissal.