Do payments made on termination always qualify for the £30,000 exemption?
No. Just because a payment is made on termination of employment does not mean that it necessarily qualifies for the £30,000 exemption. The tax treatment depends on the reason for the payment.
Termination packages may consist of many elements, for example: accrued holiday pay, bonus, payment in lieu of notice (“PILON”), continued private medical insurance and compensation. The reason for each element must be determined separately.
Generally, the £30,000 exemption applies if the payment in question is compensation for termination of employment (“Termination Payment”). The £30,000 exemption does not apply if there is some other reason for the payment, such as a reward for employment service (earnings), a payment for a new restrictive covenant or a payment on or in anticipation of retirement. Such payments are subject to income tax and NIC in full. In addition, under statutory rules relating to PILONs, the £30,000 tax exemption and NICs exemption may be reduced if any part of the Termination Payment consists of postemployment notice pay (see below).
Occasionally a payment may be made which completely falls outside the scope of income tax and NIC (for example, compensation for injury to feelings due to alleged discriminatory acts prior to termination of the employment).
We do not have a PILON clause in our contracts of employment, can we therefore pay out PILONs gross (subject to the £30,000 exemption)?
Prior to 6 April 2018, some PILONs were not taxable as earnings and benefited from the £30,000 tax exemption (and were not subject to NICs).
This was because the tax treatment of PILONs depended primarily on whether the employer had the contractual right to terminate the employee’s employment by paying a PILON rather than serving notice.
In broad terms, if the employment contract gave the employer the right to terminate by paying a PILON (a “PILON” clause”), the PILON was subject to income tax and NICs in full. In contrast, if the employment contract did not allow the employer to terminate the employment by paying a PILON but the employer did so, this “non-contractual” PILON would generally have benefited from the income tax and NICs exemption.
From 6 April 2018, the tax and NICs treatment of PILONs no longer depends on whether there is a PILON clause in the contract. If the employee’s employment terminates and the employee receives a Termination Payment on or after 6 April 2018, the employer must calculate how much of the Termination Payment (excluding any statutory redundancy pay) is post -employment notice pay (“PENP”). PENP is, broadly, the basic salary the employee would have received during any unworked period of notice, minus any contractual PILON. PENP is subject to tax and NICs in full.
PENP is calculated using the following formula:
((BP x D)/P) - T
BP = “basic pay” in the pay period which ends prior to the earlier of (i) the date on which notice is given; or (ii) if no notice is given, the termination date (“relevant pay period”).
D = the number of calendar days in the unworked period of notice.
P = the number of calendar days in the relevant pay period.
T = contractual PILON.
If the PENP is a negative number, it is treated as zero.
A simplified formula can be used where the employee is paid on a monthly basis; under the employment contract the minimum notice is a number of whole months and the unworked notice period is a number of whole months. In this situation D = the number of whole months in the unworked notice period and P = 1.
Basic pay excludes benefits, bonuses, commission, some allowances (see below) and share options/awards. However, if the employee participates in a salary sacrifice arrangement, pre-salary sacrifice salary must be used. 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.
Although employers will need to calculate PENP for each employee whose employment is terminating, including those employees whose contracts of employment contain a PILON clause, there are two situations in which PENP is likely to be zero (although this will need to be checked in each case). The first situation is where: (i) there is a contractual PILON based on a number of whole months; (ii) there is no salary sacrifice arrangement in place (or PILON is calculated on the basis of pre-salary sacrifice salary); (iii) 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. The second situation is where (i) there is a contractual PILON based on a number of weeks; (ii) there is no salary sacrifice arrangement in place (or PILON is calculated on the basis of presalary sacrifice salary); (iii) no standard cash allowances are paid (or PILON is calculated taking those allowances into account); and (iv) the relevant pay period has 31 days.
Please see our inbrief ‘Taxation of payments in lieu of notice’ for further information.
Is there NIC on Termination Payments?
No. Termination Payments are generally completely exempt from both employee and employer NIC. One exception is protective awards which qualify for the £30,000 exemption but are subject to employee and employer NIC.
However, for payments made on or after 6 April 2019, the employer NIC and income tax treatment will be aligned, so a Termination Payment which benefits from the £30,000 income tax exemption will be subject not only to income tax on the excess over £30,000 but also employer NIC. This will increase the cost to an employer of making a Termination Payment of more than £30,000 by up to 13.8% of the excess. The existing employee NIC exemption on Termination Payments will be retained, even if the payment exceeds £30,000.
We are proposing to write off an employee’s outstanding loans. Is this ok?
If the loan is written off, the amount written off will be treated as earnings on which income tax and NIC is due.
Where the Termination Payment is less than £30,000 it is better to increase the Termination Payment to enable the employee to repay the loan and therefore utilise the full exemption.
The employee is requesting that part of their Termination Payment is paid into their registered pension. Is there anything we should be aware of?
Advice should be sought where the employer is asked to pay the employee’s post-employment notice (see above) into a pension. Subject to that and to the pension scheme rules, there is no limit on the size of contributions that can be paid into a pension. In addition such a contribution, made as part of the termination arrangements, is exempt from employer and employee NIC.
However, the employee should consider both the “Annual Allowance” and the “Lifetime Allowance” from a tax perspective and should seek specialist advice on his or her personal circumstances.
Contributions can be made by or on behalf of an employee with full tax relief if, in total, they do not exceed the relevant Annual Allowance for that tax year (for 2018-19 the Annual Allowance is generally £40,000, although there are exceptions - in particular see further below for the exception which applies to high earners). In addition, subject to certain conditions, an employee may be able to carry forward any unused Annual Allowance from the previous three tax years (provided that he or she was at some point during those tax years a member of a registered pension scheme). Individuals are subject to income tax under self-assessment at their marginal rate on contributions in excess of the Annual Allowance.
For those individuals with annual incomes of more than £150,000, the Annual Allowance is reduced by £1 for every £2 of income above £150,000 up to a maximum reduction of £30,000 so that individuals with incomes of £210,000 or more will be entitled to an Annual Allowance of £10,000. An individual affected by the taper may still be entitled to carry forward unused Annual Allowance from the three previous tax years, although the amount carried forward will be limited to the unused tapered Annual Allowance in respect of any tax year in which the taper applies.
The Lifetime Allowance (which for tax year 2018- 19 is £1,030,000) must also be considered. If the value of the individual’s accrued pension rights when he or she takes the benefits exceeds the Lifetime Allowance the individual is subject to an additional tax charge.
In addition to the £30,000 exemption and making a contribution into the employee’s registered pension are there any other tax exemptions which we may be able to use on termination of employment?
Potentially, depending on the circumstances. For example:
a. The employer can pay the employee’s legal costs tax free provided the costs are incurred exclusively in connection with the termination of employment and the payment is made either pursuant to a (i) court or tribunal order; or (ii) a settlement agreement which provides for the payment to be made by the employer directly to the former employee’s solicitor.
b. If the employee had a period of ‘foreign service’ during his or her employment some or all of the Termination Payment may be exempt from income tax. A period will generally only qualify as foreign service if it relates to a period of non-UK residency and non-UK work. From 6 April 2018, employees cannot claim foreign service relief if they are tax resident in the UK in the tax year in which the employment terminates.
c. If the employee suffers from a recognised medical disability or injury which at the date the employee’s employment terminates prevents the employee from carrying out their job, a payment made solely on account of that disability or injury is exempt from income tax.
d. Compensation for alleged discrimination prior to termination of employment.
Specialist advice should be sought if you consider the exemptions in a) to d) above may be relevant.
We are paying the employee’s legal fees under a term in the compromise agreement. Can we recover the VAT?
No. You can only recover VAT on supplies made to you.
At what rate should employers deduct tax from payments made after the P45 is issued?
The employer is obliged to deduct tax using the 0T code on any payments (including share based payments) made after the P45 is issued which are subject to income tax (irrespective of whether those payments are earnings or Termination Payments which exceed the £30,000 exemption).
For tax year 2018-19 the application of the 0T code means that tax is deducted as follows:
If the application of the 0T code results in the employee paying too much (for example because the employee is not liable to tax at 40% and/or 45%) the employee will be able to claim a tax refund from HMRC.
How is NIC calculated on payments made after termination?
Where a payment which does not qualify for the £30,000 exemption and is therefore subject to NIC (for example, retention bonuses) is made after the P45 is issued, NIC is calculated using the weekly earnings period as set out in the table below. NIC on final payments of salary is calculated using the employee’s normal earnings period.
Note there are special rules for directors. For individuals who were directors at the beginning of a tax year, NIC is calculated using an annual earnings period for the remainder of the tax year regardless of when that payment is made.
Weekly earnings period limits (2018-2019):
Should we report the termination payment to HMRC?
Employers are required to report PAYE payments to HMRC in “real time” - this is referred to as Real Time Information or RTI.
Under RTI, employers are required to provide details of payments made to employees and other payroll information to HMRC generally before or at the same time as the payments are made. This information must be submitted to HMRC online using a new report known as a Full Payment Submission (“FPS”).
The PAYE processes relating to leavers mean that employers are not required to report leavers separately to HMRC - the employee’s date of leaving is simply included on the FPS. The employer must continue to issue Parts 1A and 2 of the P45 to the employee but does not need to send Part 1 of the P45 to HMRC. If payments are made to the employee after the date of leaving, the employer is required to give the employee a letter showing the date of the payment, the gross amount and the PAYE/NIC deducted.
In addition, if the termination package includes non-cash benefits and exceeds £30,000, the employer should inform HMRC by 6 July following the end of the tax year in which the termination occurred. The report should be sent to the Employer Technical Team, Employer Office, BP4009, Benton Park View, Newcastle NE98 1ZZ.