Taxing Times New Rules On Taxation Of Termination Payments

Prior to April 2018, offering an employee a termination package, via a settlement agreement, in order to bring the employment relationship to an end, was, usually, a fairly straight-forward process.

Prior to April 2018, offering an employee a termination package, via a settlement agreement, in order to bring the employment relationship to an end, was, usually, a fairly straight-forward process.

It was common for an employee without a contractual pay in lieu of notice clause (“PILON”) to be offered a lump sum payment, free of tax, so long as it was under £30,000. However, new laws have now been introduced which significantly tighten the tax treatment of termination payments. The new rules apply to payments made where both the termination of employment and payment of the termination payment occurs on or after 6 April 2018.

Why the change?

Before the introduction of the new laws, there was a lack of clarity at times as to whether tax was payable on a termination payment in circumstances where there was no pay in lieu of notice clause (“PILON”) in the contract of employment. In those cases, where the employer had paid employees in lieu in the past, there was a risk that the notice pay would be taxable. Employers could also argue that an employee’s employment had been terminated in breach of contract rather than under any PILON (implied or otherwise).

What’s new?

The new rules make it clear that where a termination payment is made, any period of unserved notice is subject to tax and class 1 national insurance contributions.

This means that tax will be payable on termination payments irrespective of whether the employee has a PILON clause in their contract or whether they have been dismissed without notice.

There are also statutory formulae to calculate what is termed Post-Employment Notice Pay (“PENP”) from which tax and NICs will be deducted. Therefore, it is not just a case of taxing the notice period as normal, even for those with contractual PILONS.

What is PENP?

Tax on Post-Employment Notice Pay, or PENP, is payable in respect of the Post-Employment Notice Period.

This is the employer’s contractual or statutory notice obligation (whichever is the greater). Where the employee has worked their notice in full, the issue of PENP will not arise. In all other cases, the PENP will need to be calculated using the correct formula. There is one formula for where an employee is paid in months and the notice period is expressed in months, and another for when this is not the case (or where any unserved notice period is not in whole months).

Both formula calculate the PENP on the basis of basic pay.

What is basic pay?

Basic Pay is defined in the legislation and essentially is the employee’s normal pay excluding overtime and bonuses. However, importantly, it is what the employee would have received had they not salary sacrificed any particular benefits. This figure is likely to be higher than that which would ordinarily be made when paying in lieu. Therefore, even if the employer has paid the employee in lieu for their notice period, subject to tax and national insurance, any termination payment made on top of that, or a proportion of it, could still be taxable, if a salary sacrifice arrangement is in place.

Once the basic pay and period of unserved notice has been calculated, the employer should then deduct any payments made under a contractual PILON to find the PENP liability.

How does that impact on us?

The new rules need to be considered and the tax liability calculated (so far as it can be) before an offer of termination is made so it is clear what the employee will receive. Ultimately, it will mean a higher cost to employers and employees will lose any tax advantage from not having a contractual PILON.

Settlement agreements should also be amended to clearly set out the tax treatment of the termination payment, and where possible, the PENP.

Employees may also be more likely to resist a standard tax indemnity.