Introduction

Income tax and national insurance contributions (NICs) must be paid on all payments in lieu of notice (PILONs) from April 6 2018.

The new rules emerged from a government consultation on the simplification of the tax treatment of termination payments, which was launched in 2012. However, far from simplifying their taxation, the rules impose a complex administrative burden on employers and are likely to increase the costs to both employers and employees.

Previous rules

At present, some PILONs may benefit from a tax exemption for termination payments that are not taxable as earnings. Such payments are not subject to NICs and up to £30,000 can be paid tax free.

The tax treatment of a PILON depends primarily on whether the employer has the contractual right to terminate the employee's employment by paying a PILON, rather than serving notice.

If the employment contract gives the employer the right to terminate the employment by paying a PILON, the PILON is generally subject to income tax and NICs in full. In contrast, if the employment contract does not allow the employer to terminate the employment by paying a PILON, but the employer does so, the so-called 'non-contractual PILON' generally benefits from income tax and NIC exemption.

However, there are exceptions. For example, even if no PILON clause exists in the contract, Her Majesty's Revenue and Customs (HMRC) may argue that a non-contractual PILON is subject to tax and NICs in full if the employer invariably pays PILONs to employees, without requiring the employee to mitigate his or her losses. Conversely, if a PILON clause exists, it may be argued in appropriate circumstances that the employment has not been terminated in accordance with the terms of the employment contract; therefore, any amount that the employee receives is eligible for income tax and NIC exemption.

New rules

From April 6 2018, employers that pay a relevant termination award to an employee must calculate how much of the award is post-employment notice pay (PENP). 'PENP' is the basic salary that the employee would have received during any unworked period of notice minus any contractual PILON.

PENP is subject to income tax and NICs in full.

Until April 5 2019 the balance of the relevant termination award is eligible for the £30,000 tax exemption and full NIC exemption. For payments made after this date, the employer's NIC exemption will be limited to the first £30,000, but the employee's NIC exemption will remain.

A 'relevant termination award' is any payment or benefit which compensates individuals for the termination of their employment (ie, payments and benefits which would have qualified for the £30,000 tax exemption before April 6 2018), excluding any statutory redundancy pay.

PENP is calculated using the formula ((BP x D)/P) - T, where:

  • 'BP' is the basic pay in the pay period before the date on which notice is given or, if no notice is given, the termination date. Basic pay excludes benefits, bonuses, commission, allowances, share options or awards. However, if the employee participates in a salary sacrifice arrangement, pre-salary sacrifice salary must be used;
  • 'D' is the number of days in the post-employment notice period (or the number of whole months where, under the employment contract, the minimum notice is a number of whole months). The 'post-employment notice period' is the period from the employee's actual termination date to the earliest date on which the employment could have been terminated;
  • 'P' is the number of days in the pay period before the earlier of:
    • the termination date; or
    • the date on which notice was given or, it is one where, under the employment contract, the minimum notice is a number of whole months; and
  • 'T' is the contractual PILON.

Separate rules apply to fixed-term contracts which generally mean that income tax and NICs are payable on the amount of basic pay that employees would have earned if they had worked the remainder of their fixed term.

Example 1: non-contractual PILON At the end of June 2018, Mary is told that she is being made redundant. She must leave her job immediately without working her notice. Her employment contract has a 12-week notice period. There is no PILON clause. Mary is paid monthly and her monthly gross basic salary is £4,000 per month (£48,000 per year). She does not participate in any salary sacrifice arrangement. Mary receives a total ex gratia termination payment of £16,000, including £4,000 statutory redundancy payment.

Mary's relevant termination award is £12,000 (£16,000 - £4,000).

Mary's PENP is £11,200 ((£4,000 x 84)/30).

This means that:

  • the statutory redundancy payment of £4,000 benefits from the £30,000 tax exemption and 100% NIC exemption;
  • the PENP of £11,200 is subject to tax and NICs in full; and
  • the balance of the relevant termination award of £800 benefits from the £30,000 tax exemption and 100% NIC exemption.

Example 2: contractual PILON with a salary sacrifice At the end of June 2018, Jo is told that she is being made redundant. She must leave her job immediately without working her notice. Her employment contract provides for a three-month notice period or a payment in lieu of notice equal to three months' basic salary. Jo is paid monthly and her monthly gross basic salary is £3,750 per month (£45,000 per year). Jo participates in a pension salary sacrifice arrangement under which she sacrifices £250 gross per month (£3,000 per year); therefore, her monthly pre-salary sacrifice pay is £4,000. Jo receives:

  • £11,250 PILON;
  • a £4,000 ex gratia payment, including £3,500 statutory redundancy payment; and
  • a £750 pension contribution.

Jo's relevant termination award is £500 (£4,000 - £3,500). The pension contribution is ignored for these purposes.

Jo's PENP is £750 (((£4,000 x 3)/1) - £11,250).

This means that:

  • the statutory redundancy payment of £3,500 benefits from the £30,000 tax exemption and 100% NIC exemption;
  • the contractual PILON of £11,250 is subject to income tax and NICs in full; and
  • the PENP of £500 (restricted to the amount of the relevant termination award) is subject to income tax and NICs in full.

Implications

Employers should calculate the PENP for each employee whose employment is terminating, including those whose employment contracts contain a PILON clause. Although, where a contractual PILON is expressed in a number of whole months and the employee does not participate in a salary sacrifice arrangement, the contractual PILON will likely be at least equal to the PENP.

From April 6 2018, paying a non-contractual PILON will cost employers (and potentially employees) more. This is because the employer will have to pay employer NICs at 13.8% on the PENP and the employee will have to pay income tax and employee NICs on the PENP.

Salary sacrifice arrangements (including valid arrangements implemented before any thought of terminating the employee's employment) are ignored for the purposes of calculating the PENP. Therefore, from April 6 2018, where salary sacrifice arrangements are in place, paying a PILON is likely to cost employers (and potentially employees) more – irrespective of whether the employment contract contains a PILON clause. This is because the employer will have to pay employer NICs on the salary sacrificed and the employee will have to pay income tax and employee NICs on that salary.

There may be ways to mitigate the effect of the new rules – for example, reducing the amount of the relevant termination award by making a contribution into the employee's pension. However, there are wide anti-avoidance provisions, so care will be needed.

When do the new rules take effect?

The new rules were widely understood to take effect for any payments made on or after April 6 2018. However, HMRC has stated that the new rules will likely take effect only if the employment terminates after April 5 2018. In other words, the new rules may not apply if the employment terminates before April 6 2018, even if the payment is made on or after April 6 2018.

HMRC is expected to produce guidance on the new rules, which is likely to be available in March 2018, to clarify this point and others arising from the legislation. Guidance will be welcome sooner rather than later – this level of uncertainty is unhelpful at a time when employers should be starting to consider and prepare for the new rules.

For further information on this topic please contact Victoria Goode at Lewis Silkin by telephone (+44 20 7074 8000?) or email (victoria.goode@lewissilkin.com). The Lewis Silkin website can be accessed at www.lewissilkin.com.

This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.