HM Revenue & Customs has published guidance on the new rules that require income tax and national insurance contributions (NICs) to be paid on all payments in lieu of notice (“PILONS”) with effect from 6 April 2018.

The detailed guidance is contained in an updated version of the HMRC’s Employment Income Manual (see paragraphs 13874 to 13898), together with a worked example.

While the guidance had been eagerly awaited, given the uncertainty over how the rules will operate in practice (highlighted in our previous article), it still leaves a number of questions unanswered. In addition, HMRC’s approach to allowances (see below) is likely substantially to increase the amount subject to income tax and NICs in situations where the employee receives standard allowances such as a car allowance.

In light of the new guidance, this article provides an overview of the new regime, how it will operate in practice and some of the continuing areas of uncertainty.

The new rules

Where an employee’s employment terminates after 5 April 2018 and he or she receives a payment after that date, the basic salary that the employee would have received for any period of unworked notice is subject to income tax and NICs in full. This is irrespective of whether there is a PILON clause in the contract.

Under the new rules, if an employee is paid in lieu of some or all of his or her notice period, the employer must deductincome tax and employee NICs from, and pay employer NICs on, the employee’s “post-employment notice pay” (PENP).

How is PENP calculated?

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” (see below)

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

T = the contractual PILON.

A simplified formula can be used where:

• the employee is paid monthly;
• under the employment contract the minimum notice is a number of whole months; and
• the unworked period of notice is a number of whole months.

In this situation, D = the number of whole months in the post-employment notice period and P = 1.

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

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”. This suggests that standard allowances such as car allowances 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 employees in receipt of these types of allowances.

The “post-employment notice period” is the period from the end of the day on which the employee’s employment terminates to the earliest date on which the employer could have lawfully terminated the employment.

What happens if the employee is on a fixed-term contract?

There are separate rules dealing with fixed-term contracts where the contract does not include a requirement for notice to be given by either the employee or the employer. In broad terms, the basic pay that the employee would have received in the period beginning on the day after the employment terminates and ending on the date on which the “limiting event” occurs is subject to income tax and NICs in full. The limiting event is the expiry of the fixed term, the performance of a specific task or the occurrence of a specific event.

What is impact do the new rules have on an employee’s termination payment?

The employer has to deduct the PENP from the employee’s “relevant termination award”. This is any payment or benefit which compensates the individual for the termination of their employment (i.e. those payments and benefits which prior to 6 April 2018 would have qualified for the £30,000 tax exemption), excluding any statutory redundancy pay.

PENP is subject to income tax and NICs in full.

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

What are the implications of the new rules?

• If the employee works out their full notice or is put on garden leave for their full notice, the new rules do not apply.
• In those situations where the new rules apply, the employer will need to ensure any settlement agreement makes clear that the employer will deduct income tax and employee NICs from PENP.
• Employers will need to calculate the PENP for each employee whose employment is terminating, including those employees whose contracts of employment contain a PILON clause. Employees are likely to want to see this calculation before signing any settlement agreement.
• If the PILON is contractual, however, there are two limited scenarios where the PENP is likely to be zero. This depends on how the contractual PILON is calculated and will still need to be checked in every case.

Scenario 1

The PENP is likely to be zero if:

• there is a contractual PILON based on a number of whole months;
• there is no salary sacrifice arrangement in place (or PILON is calculated on the basis of pre-salary sacrifice salary);
• ·no standard cash allowances are paid (or PILON is calculated taking those allowances into account); and
• the unworked period of notice is in a number of whole months.

Scenario 2

The PENP is likely to be zero if:

• there is a contractual PILON based on a number of weeks;
• there is no salary sacrifice arrangement in place (or PILON is calculated on the basis of pre salary pre salary sacrifice salary);
• ·no standard cash allowances are paid (or PILON is calculated taking those allowances into account); and
• the relevant pay period has 31 days.
• From 6 April 2018, there is no tax disadvantage in having a PILON clause for basic salary in the contract.

What areas of uncertainty remain?

There are a number of situations in which it is uncertain how the new rules will apply and employers should seek specific advice:

• The first uncertainty concerns the anti-avoidance provisions which allow HMRC to ignore any arrangements that are designed to reduce PENP. It is unclear how these apply where the employee asks for some or all of the relevant termination award to be paid into his or her pension. Pension contributions would normally fall outside the new rules, but it is possible that HMRC would view a request for a pension contribution as an arrangement to reduce PENP. It might therefore seek tax and NICs on the relevant termination award as if the pension contribution had not been made.
• It is unclear how the new rules apply where the employee has received no pay in the relevant pay period (for example, because the employee had exhausted their entitlement to both company and statutory sick pay). Presumably, basic pay and therefore PENP would be nil in these circumstances and the new rules would not apply.
• If an employee’s employment is terminated summarily without notice or pay in lieu of notice, it is unclear whether it is necessary to apply the PENP calculation to any relevant termination award the employee receives. The more cautious approach is for employers to calculate PENP and apply tax and NICs to it.
• In some cases, the period of notice the employee has to give may be less than the period of notice the employer has to give. However, the amount of PENP is calculated on the basis of the employer’s notice period. As a result, if the employee resigns and receives a relevant termination award, the PENP must be calculated based on the notice period that would have been required from the employer (rather than the shorter notice actually given by the employee).

Future developments

Further guidance on the practical operation of these new rules would be helpful for employers grappling with their implementation, particularly given the areas of continuing uncertainty, but HMRC has not given any indication that further guidance will be forthcoming.

Given the complexity of the formulae explained above, we have put together an Excel spreadsheet to help employers calculate PENP. If you have any questions about the new rules or would like a copy of our PENP spreadsheet, please get in touch with your usual Lewis Silkin contact.