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

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

Current rules

Currently, 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.

In broad terms, 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 (a “non-contractual PILON”), the non-contractual PILON generally benefits from the income tax and NICs exemption.

There are exceptions. For example, even if there is no PILON clause in the contract, 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 their losses. Conversely, if there is a PILON clause, it may be possible, in appropriate circumstances, to argue that the employment has not been terminated in accordance with the terms of the employment contract and therefore any amount the employee receives is eligible for the tax and NICs exemption.

New rules

With effect from 6 April 2018 if an employer pays a “relevant termination award” to an employee the employer has to calculate how much of the relevant termination award 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 income tax and NICs in full.

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

A relevant termination award 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 calculated using the following formula:

((BP x D)/P) – T

Where:

BP = “basic pay” in the pay period prior to 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/awards but, if the employee participates in a salary sacrifice arrangement, pre-salary sacrifice salary must be used.

D = the number of days in the post-employment notice period (or, where under the employment contract, the minimum notice is a number of whole months, the 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 terminated.

P = the number of days in the pay period prior to the earlier of the termination date or the date notice is given (or, where under the employment contract the minimum notice is a number of whole months, 1).

T = contractual PILON.

There are separate rules dealing with fixed term contracts that generally mean income tax and NICs are payable on the amount of basic pay the employee 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 has to 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:

  • Statutory redundancy payment of £4,000 benefits from the £30,000 tax exemption and 100% NICs exemption.
  • PENP of £11,200 is subject to tax and NICs in full.
  • The balance of the relevant termination award of £800 benefits from the 30,000 tax exemption and 100% NICs 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 has to 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 complete 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) so 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:

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

What are the implications of the new rules?

  • 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. That said, where there is a contractual PILON expressed in a number of whole months and the employee does not participate in a salary sacrifice arrangement, it is likely that the contractual PILON will be at least equal to the PENP.
  • With effect from 6 April 2018, paying a non-contractual PILON will cost the employer (and potentially the employee) 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. This means that, with effect from 6 April 2018, where salary sacrifice arrangements are in place, irrespective of whether the employee’s employment contract contains a PILON clause, paying a PILON is likely to cost the employer (and potentially the employee) more. 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?

It was widely understood that the new rules would take effect for any payments made on or after 6 April 2018. However, we have heard from HMRC that it is likely that the new rules will only take effect if the employment terminates after 5 April 2018 – in other words the new rules may not apply if the employment terminates before 6 April 2018 even if the payment is made on or after 6 April 2018.

We understand that HMRC is producing guidance on the new rules (which is likely to be available in March) to clarify this point and others arising from the legislation. Guidance sooner rather than later will be welcome – this level of uncertainty is unhelpful at a time when employers need to start considering and preparing for the new rules.