Many of our clients in the retail, fashion and hospitality sector face similar HR issues. Each month one of the members of our team will identify an issue, ask how you would deal with it and provide our advice. This month we asked Emma...

Help! I’m an HR manager in a restaurant company and need some advice about a settlement agreement for an agreed exit for one of our operations managers, Jonna, on 10 May 2018. In addition to a payment for outstanding holiday, she will receive a £11,077 payment in lieu of notice (PILON) for her 12-week statutory notice period (her contractual notice is one month but she has been with us 14 years). We’ll also include an ex-gratia payment of £8,000 and a contribution to pension of £600. Jonna’s annual salary is £48,000 and she is entitled to a monthly car allowance of £450.

There is no PILON clause in Jonna’s contract. I thought this meant we could pay the PILON free of tax and national insurance contributions (NICs), but then I remembered the law changed at the start of the new tax year and PILONs are now all subject to tax and NICs. I assumed this would be really simple and we would just apply deductions to the 12-week PILON based on our usual calculation method (annual basic salary/52 x 12). However, I read an article on an HR website which talks about calculating “post-employment notice pay” to work out how much pay is subject to deductions. Now I’m really confused!

What do we do regarding tax and NICs on the PILON payment?

A. Essentially nothing has really changed. If there’s no PILON clause in the contract, you don’t have to pay tax or NICs on the PILON.

B. It is as simple as you think! You just need to remember that tax and NICs now need to be deducted from all PILONs. The settlement agreement should make this clear, so Jonna is aware, but you’ll need to make the deductions by law whatever the agreement says.

C. You now have to pay tax and NICs on an employee’s “post-employment notice pay”, which is based on a statutory calculation. You need to make clear in Jonna’s settlement agreement that you will be applying deductions to the PENP.

D. You have to pay tax and NICs on Jonna’s PENP, in line with the statutory calculation. In the situation you have described, however, this will essentially come to the same thing as applying PAYE deductions to the PILON.

The correct answer is C.

The new rules – discussed here - apply to terminations on or after 6 April 2018. Under these, the basic salary that the employee would have received for any period of unworked notice is subject to income tax and NICs in full, irrespective of whether there is a PILON clause in the contract. This means that as of that date there is no tax disadvantage in having a PILON clause for basic salary in the contract.

But it is not just a simple matter of applying these deductions to what may be your usual way of calculating a PILON. And it will not necessarily be based on what you think of as “basic pay”. Under the new rules, if an employee is paid in lieu of some or all of his or her notice period, the employer must deduct tax and NICs from, and pay employer NICs on, the employee’s “post-employment notice pay” (PENP).

There is a statutory formula for calculating PENP. You need to do this calculation even if the employee’s contract includes a PILON payment.

PENP is generally calculated using the following formula:

((BP x D)/P) – T

Where:

BP = “basic pay” in the pay period which ends prior to the date on which notice is given (if any) or, if no notice is given, the termination date (“relevant pay period”)

D = the number of calendar days in the “post-employment notice period” - essentially the period from the termination date to the earliest date on which the employer could lawfully terminate the employee’s employment by notice.

P = the number of calendar days in the relevant pay period

T = contractual PILON.

Basic pay excludes benefits, bonuses, commission, allowances (see below), share options/awards. However, if the employee participates in a salary sacrifice arrangement, pre-salary sacrifice salary must be used for the calculation.

The rules around “allowances” are complex. HMRC guidance states that an “allowance” is a supplementary payment received by an employee over and above their standard pay, but it does not include “any amount which is actually, or in reality reflects an amount which has been, consolidated into an employee’s standard pay”. We believe this means that standard allowances, such as Jonna’s car allowance, or allowances in lieu of pension contributions should be included in the calculation of basic pay. This is likely to increase substantially the amount of PENP (in comparison to any contractual PILON) for those employees in receipt of these types of allowances.

Once you have calculated the PENP, you need to deduct it from the employee’s “relevant termination award”. This is any payment or benefit which compensates the employee for the termination of their employment - i.e. those payments and benefits which before 6 April 2018 would have qualified for the £30,000 tax exemption. Any statutory redundancy pay is excluded (which isn’t relevant in Jonna’s case).

PENP is subject to income tax and NICs in full.

Any statutory redundancy payment and the balance of the relevant termination award benefits from the £30,000 tax exemption and NICs exemption. If the relevant termination award is less than the PENP, then the entire award is subject to income tax and NICs.

So, what does this mean in practice for the termination package you are preparing for Jonna?

Assuming she does not work any of her notice period and her employment ends as planned on 10 May 2018:

  • Jonna’s “relevant termination award” is the non-contractual PILON plus the ex-gratia payment, i.e. £19,077. The pension payment is ignored for these calculations.
  • Her PENP is:

    (4,450 x 84)/30 = £12,460. (There is no contractual PILON so “T” from the formula above is not deducted. Note that if the car allowance of £450 were not included, the PENP would be lower.)

  • PENP of £12,460 is subject to tax and NICs in full.
  • The balance of the ex-gratia payment is £19,077 minus £12,460, which comes to £6,617. This benefits from the maximum £30,000 tax exemption and 100% NICs exemption.

As noted above, you should make clear in the settlement agreement that the PENP is subject to tax and NICs. It is likely that Jonna will want to know how much the PENP is before signing the agreement.

As the PENP formula is quite complicated, we have prepared an Excel tool to help employers calculate it. If you would like a copy of this or have any questions about the new rules, please get in touch with your usual Lewis Silkin contact.