Are you ready for the upcoming Government reforms to the tax treatment of termination payments? Amongst other things, the rules on the taxation of payments in lieu of notice (PILON) are to be tightened and clarified.
What's the current position?
Certain PILONs are already subject to income tax and National insurance Contributions (NICs), such as where there is a contractual PILON clause or where there is an established practice of making PILONs.
Other PILONs, however, are treated as "damages" and currently fall within section 401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). This means that the first £30,000 of such payments are exempt from tax and NICs.
All PILONs are to be subject to tax and NICs, irrespective of the circumstances in which they are made.
Employers will be required to treat part of a termination payment which reflects basic pay for any part of a notice period that is not served as earnings. This taxable amount is referred to in ITEPA 2003 as "post-employment notice pay" (PENP), which will be the sum the employee would have received if the full period of notice was worked. For example, in simple terms:
- An employee is paid £2,000 basic pay per month.
- He has a 3-month notice period.
- He works only 1 month of his notice period.
- He receives a termination payment of £8,000.
- £4,000 of this termination payment could be treated as PENP (being 2 (months) x £2,000).
However, if part of the termination payment is a statutory redundancy payment (SRP), the SRP should be treated separately as it will qualify for the tax free exemption (e.g. if, in the above example, the termination payment included an SRP of £5,000, then only £3,000 would be treated as a PENP).
The reforms take effect from 6 April 2018. Where termination occurs on or after that date, the new rules will apply.
What do we need to do?
From 6 April 2018 employers should ensure that termination payments are treated in accordance with the new rules.
Remember, it is the employer who will be responsible to account for these sums and it is the employer who HMRC will generally pursue for any unpaid sums.
Getting it right the first time is important. While settlement agreements entered into on termination may include a tax indemnity in favour of the employer, seeking to rely on such an indemnity often presents its own problems.