Taxing Termination Payments- New Regime from 6 April 2018

From 6 April 2018, a new regime will apply to payments in lieu of notice (PILON) paid on termination of employment.

Current position

The current position is that the tax treatment of a PILON depends on whether there is a contractual PILON clause in the contract of employment. If there is, the PILON will be taxable. If there is not, typically the PILON can be paid tax free. Further, although income tax is due on termination payments in excess of £30,000, neither employer’s nor employee’s national insurance contributions apply.

The Government indicated last year their intention to “clarify and tighten” the treatment of Termination Payments. As such, Section 5 of the Finance (No.2) Act 2017 inserts sections 402A to 402E into Chapter 3 of Part 6 of the Income Tax (Earnings and Pensions) Act 2003.

New regime

Essentially, under the new regime the intention is to tax (and subject to class 1 national insurance contributions) as earnings the basic pay an employee would have earned had the employee worked his or her notice in full.

This requires employers to split a termination award between amounts treated as earnings (section 402B, ITEPA 2003) and amounts benefitting from the £30,000 exemption (section 403, ITEPA 2003). In other words, employers must treat a slice of a termination award, which reflects basic pay for any part of a notice period that is not served, as earnings and subject that slice to tax and NICs (employer and employee).

This affects where both the payment is made and the termination date is after 6 April 2018.

What is a termination award?

A termination award is a payment or other benefit received directly or indirectly in connection with the termination of a person’s employment.

However, the first point to note is that “termination awards” do not include:

• statutory redundancy pay and approved contractual pay (to the extent that it does not exceed the statutory redundancy pay). These automatically benefit from the £30,000 exemption;
• payments or other benefits chargeable to tax apart from Chapter 3 (e.g. restrictive covenants and contractual PILONs).

These can therefore be excluded from the following calculation.

What must be taxed as earnings?

Once you have considered whether there is a termination award (noting that if only a contractual PILON is paid there is no termination award), the amount to be treated as earnings is calculated by reference to “post-employment notice pay” (PENP).

The basic formula to calculate PENP (for an employee who is paid monthly, whose contractual notice period is expressed in months and whose employment is terminated with immediate effect or whose unworked period of notice is a whole number of months) is:

BP x D – T

Where:

• BP is basic pay for the last pay period to end before the day notice is given. This includes any sums that have been salary sacrificed but excludes any sums such as overtime, bonuses, commission, gratuities, allowance and benefits on kind.
• D is the number of months in the post-employment notice period (i.e. the unworked period of notice, based on the employer’s notice period, not the employee’s notice period).
• T is amounts, other than holiday pay and termination bonuses, that are paid on termination but are taxable as earnings.

If the employee is not paid monthly or the employee’s notice period is not expressed in months, the formula is:

BP/P x D – T

Where:

• BP is basic pay for the last pay period to end before the day notice is given.
• P is the number of days in the pay period.
• D is the number of days in the post-employment notice period (i.e. the unworked period of notice, again based on the employer’s notice period).
• T is amounts, other than holiday pay and termination bonuses, that are paid on termination but are taxable as earnings.

The slice of the termination award to be treated as earnings and therefore taxed is then:

• The entire termination award if PENP is equal to or more than the termination award.
• The PENP, if it is less than the termination award but is not nil.

If PENP is a negative amount, it is treated as nil.

As mentioned above, you should ensure that you have not included the statutory redundancy payment within the termination award.

Other changes

The other key change from 6 April 2018 is that Foreign Service Relief has been removed for termination payments for employees who have spent significant periods working overseas.

Further, from 6 April 2019, employer’s national insurance contributions will be due, alongside income tax, on any termination payments made in excess of the £30,000 exemption. Termination payments will remain exempt from employee’s NICs.

What this means for Employers

Given that employees will now be taxed on their PILON whether they have a contractual PILON clause or not, it is likely that employees will seek additional sums to counteract the affect of this.

In contrast, the fact that, from 6 April, 2019, employers will now have to make national insurance contributions on any sum in excess of the £30,000 exemption may lead employers to reduce the termination award accordingly.

These competing interests are therefore likely to make termination negotiations more difficult.

In addition, whilst we have given a broad overview of the new regime above, there are some technicalities which mean that employers will need to grapple with the legislation in calculating the tax due on any termination award.

It would therefore be worth familiarising yourself with the legislation and seeking further advice on anything you are unsure about, in readiness for 6 April 2018.

Please email me if you have any queries on anything mentioned above.

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