The current rules for taxation of termination payments are complex, and the exemptions incentivise employers to structure payments into the exempt categories to minimise the Income Tax and National Insurance due. Speaking with Lawyer Monthly, Amy Richardson, Associate at Coffin Mew, explains in depth below.
From 06 April this year, the way that termination payments (and in particular payments in lieu of notice) are treated for tax purposes will change. The key changes are:
Payments in lieu of notice
Payments in lieu of notice (PILON) have always been a ‘grey area’ when negotiating settlement packages. Many employers take the view that if there isn’t an express PILON clause in the contract of employment, or if the clause is discretionary, then this allows them to make the payment tax free. Employees prefer the payment to be made tax free as they get more in their pocket, so it suits both parties. However, HMRC understandably doesn’t like this approach as it is missing out on the tax and NI from those payments.
From 06 April 2018, all PILONs will be subject to tax and NICs, regardless of whether there is a clause in the employment contract or not.
This measure is intended to bring fairness and clarity to the taxation of termination payments by making it clear that all PILONs, rather than just contractual PILONs, are taxable earnings. All employees will pay tax and Class 1 NICs on the amount of basic pay that they would have received if they had worked their notice in full, even if they are not paid a contractual PILON. This means the tax and NICs consequences are the same for everyone and it is no longer dependent on how the employment contract is drafted or whether payments are structured in some other form, such as damages.
The legislation requires the employer to identify the amount of basic pay that the employee would have received if they had worked their notice period, even if the employee leaves the employment part way through their notice period. The amount will be treated as earnings and will not be subject to the £30,000 Income Tax exemption. Basic pay, for these purposes, will include any sums set aside for salary sacrifice, but will not include an employee’s expected bonus income, overtime or benefits in kind.
The £30,000 exemptions
The existing £30,000 Income Tax exemption will be retained but some clarifications have been made.
- Redundancy pay:
Statutory and contractual redundancy pay will continue to benefit from the £30,000 exemption.
- Foreign service relief will be removed:
This relief is currently available to employees who are UK tax residents but, during the course of their employment, have worked overseas. They are able to claim a deduction in the taxation of a termination payment provided they meet relevant criteria – however this relief is being removed except for seafarers.
- Damages for injury to feelings:
The legislation clarifies that the exemption for injury does not apply in cases of injured feelings. This is relevant when the employee has alleged discrimination and any compensation sums that the parties have allocated for ‘injury to feelings’ will not fall within the tax-free exemption.
All payments in excess of £30,000 to be subject to employers NICs
Employees will continue to benefit from an unlimited employee NICs exemption for payments associated with the termination of employment.
However, an employer will be required to pay NICs on any part of a termination payment that exceeds the £30,000 threshold. It is anticipated that this will be collected in ‘real-time’, as part of the employer’s standard weekly or monthly payroll returns and remittances to HMRC.
This change has been delayed and will come into force in April 2019.
Employers who are considering making settlement offers to employees should aim to wrap these up before the 06 April changes come in so as to benefit from the current, and more generous, tax rules on termination payments. It’s important to note that these new rules relate to payments made from 6 April 2018 and the actual date of termination of employment is irrelevant. So not only should the agreements be finalised before that date, but the actual payments should also have been made on or before 5 April 2018.
In addition, employers who have avoided putting PILON clauses in their contracts so that they have the flexibility of making tax free termination payments should be warned that there is now no tax advantage to not having a clause, and in fact, by making a payment in lieu of notice where there is no entitlement in the contract has the effect of rendering any restrictive covenants void. These employers should now consider adding a PILON clause into all future contracts.