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How tax changes will increase the cost of terminations

The tax treatment of some termination payments has recently changed. New, more complicated rules came into force on Thursday 5 April 2018, which apply to the payments made to employees in lieu of them working out their notice.

1. Background

HMRC signalled changes to the tax and National Insurance Contribution (NIC) treatment of payments made at the end of employment because employers were manipulating the rules by structuring arrangements to minimise tax deductions.

Payments due under the employee’s contract (e.g. holiday pay and bonuses) are generally chargeable to income tax and NICs. An employer paying an employee in lieu of notice under a contractual clause had to tax the payment in lieu of notice. However, some employers were not giving notice or were making payments in lieu without any right in the contract, and seeking to pay that sum as an “ex gratia” or “Termination Payment”, without any deduction of tax up to £30,000. This is because Termination Payments, which are not otherwise taxable, benefit from a £30,000 tax exemption (e.g. redundancy pay).

2. Payments In Lieu of Notice (PILONs)

HMRC has wised-up to these practices and has sought to tax “disguised” notice payments. Even if the contract did not contain a PILON clause, if the employer’s “customary” or “automatic” response to termination was to make a payment instead of the employees working out their notice, HMRC would require tax and NICs to be paid on the part of the ex gratia payment that equated to notice pay.

3. What changed?

For terminations after Thursday 5 April 2018, all payments in lieu of notice (whether permitted by the contract or not) will be treated as general earnings and subject to deductions for tax on the full amount. An employee will no longer be able to be paid a tax-free sum equivalent to their notice pay rolled-up in to a £30,000 tax-free amount.

4. Why does it matter?

Employers will now need to tax all “post-employment notice pay,” even if no notice is given or the employee is allowed to leave before the end of their notice period. Instead of paying a gross payment up to £30,000, the sum the employee should have received for their notice period will now be reduced by tax. Employees will therefore receive a net sum, rather than the previous gross sum. An employer negotiating settlements with an employee will now have to consider “topping-up” that payment, so that the employee receives the level of compensation they would have received prior to the change.

The good news for employers and employees is that redundancy payments and payments for loss of employment will continue to benefit from the £30,000 exemption, as long as there is no disguised notice pay included in them. However, HMRC has created a new category referred to as “post-employment notice pay” which will not be tax-free, and employers will need to decide what element of the payment falls into this category. Despite aiming to bring simplicity, this new approach is far from straightforward. This adds increased cost in the payroll, as well as the administration of which termination payments benefit from the threshold (£30,000 exemption) and which do not.

5. How will post-employment notice pay be calculated?

Employers will need to understand how HMRC calculates post-employment notice pay in order to determine how the termination payment will be taxed, and how much, if any, is subject to PAYE deductions. The calculation is tricky and HMRC will pursue an employer for any under-deduction of PAYE.

6. When did these changes come into effect?

The new rules relate to payments where employment ended on or after Thursday 5 April 2018. An employee whose employment terminated on Saturday 31 March 2018, but who received their termination payment on Friday 6 April 2018, won’t be caught. Employers can’t agree to reduce the contractual notice period.

This change increases the tax liability on termination payments. HMRC is removing loopholes and adding complexity. It would be helpful if future changes were simpler for businesses and employees.

For further help, please contact Melanie Stancliffe (Employment Partner) at melanie.stancliffe@irwinmitchell.com or Paul Spenceley (Tax Manager) at paul.spenceley@irwinmitchell.com.

Alternatively you can call 0870 1500 100.

Autumn 2018

Key Contact

Melanie Stancliffe