The tax treatment of some termination payments is changing. From 6 April 2018, new rules apply to non-contractual PILONs that are more complicated than you might expect.
Our tax expert Paul Spenceley explains the detail.
Over the last couple of years, HMRC has been consulting on changes to the tax and NIC treatment of termination payments. Their view is that the current rules are unnecessarily complex and the exemptions incentivise employers to manipulate the rules by structuring arrangements to minimise the tax and NIC due.
A “termination payment” is any payment that is not already chargeable to income tax and does not include contractual payments (such as PILON, holiday pay, bonuses etc.), restrictive covenants, payments caught by the legislation covering Employer-financed retirement benefits etc. All these are taxable in full and are not eligible for consideration under the £30,000 tax exemption.
This area has been complicated over the years because HMRC has sought to tax contractual and discretionary PILON payments as general earnings rather than as termination payments. HMRC has also sought to tax non-contractual PILONs made to staff where this amounts to a “customary” or “automatic” response to termination as general earnings.
However, if you do not have a contractual right to make a PILON (and it is not caught by the “customary” or “automatic” provisions set out above) you will breach the employee’s contract of employment by making one. Under the existing rules, this payment will be treated as damages and will form part of the termination payment and the first £30,000 of any termination payment is usually tax-free.
Many employers do not realise that, as a damages payment, their obligation to the employee is based on what a court would award the employee if he sued for breach of contract. This is equivalent to the employee’s
net rather than gross pay. HMRC are concerned that where employers are aware of this they have structured termination payments to avoid tax by, for example, treating the entire amount as an ex gratia payment.
What is changing?
Contractual PILON payments will continue to be treated as general earnings and will be taxable in full.
However, termination payments will be divided into two categories – those that benefit from the threshold (£30,000 exemption) and those that do not.
Normal termination payments will continue to benefit from the £30,000 exemption but HMRC has created a new category referred to as “post-employment notice pay” which will not, and employers will need to decide what element of the payment falls into each category.
How will post employment notice pay be calculated?
Employers will need to understand how HMRC calculate post-employment notice pay to be able to determine how the termination payment will be taxed and how much, if any, is subject to PAYE. If you fail to withhold the correct amount of PAYE, HMRC will pursue you for the under-deduction.
HMRC will assume that any termination payment will include post-employment notice pay if the employee is not required to work their full notice, either contractual or statutory (whichever is the longer). The amount of post-employment notice pay is calculated using the formula (BP x D/P) minus T. These are expressed as follows:
BP – Basic Pay
D – Length of the Post-employment notice period
P – number of days in the pay period used to calculate Basic Pay
T – The total amount of the termination payment less any amount that is already taxed as earnings, statutory redundancy pay, holiday pay for a period before the employment ends or a bonus payable for termination of the employment.
In calculating “Basic Pay” you must take the employee’s taxable employment income in the final pay period before the employment ended plus any amount that the employee had given up the right to receive (salary sacrifice) but disregarding:
Any amount received by way of overtime, bonus, commission, gratuity or allowance
Any amount received in connection with the termination of the employment
Any benefits in kind
Any amount that relates to company sick pay, restrictive undertakings and certain amounts that relate to employee shareholders
Any amount that relates to shares or share options
There are anti-avoidance provisions to stop employees/employers reducing the contractual notice period as part of the termination agreement.
It is possible that the above formula will result in a negative answer in which case the post-employment notice pay will be nil.
In cases where the only payment made to the employee is a non-contractual PILON it will become subject to income tax and will not benefit from the £30,000 exemption. However, if you decide to pay less PILON damages but additional termination payments (such as non-statutory redundancy pay, ex-gratia or compensation for loss of office) you will have a complex computation to make to determine what element is taxable.
When do these changes come into effect?
The new rules relate to
payments* made from 6 April 2018 and have no bearing on the actual date of termination of the employment. For example, an employee whose employment terminated on 31 March 2018, but who receives their termination payment on 14 April 2018, will be fully caught by the new rules. However, an employee whose employment terminated on 1 April 2018, who received a 12 month non-contractual PILON on 3 April 2018, will not be caught by the new rules at all.
If you do not want to be caught by the new rules you must make sure you structure any new settlement agreements and make any termination payments before 6 April (even if this means they are made outside the normal payroll run). Don’t let your payroll dictate when payments are made.
*HMRC have just announced (Feb 2018) that the new rules on the taxation of non-contractual payments in lieu of notice apply to terminations after 5 April – rather than to payments made after that date. This interpretation is not set out in published legislation, but HMRC may now find it difficult to argue against its own view!
Are there any other relevant changes?
Yes. Foreign Service Relief will no longer be available on termination payments where the employee is a UK tax resident in the year their employment ends.
Under the current rules where an employee has, during the course of their employment with a particular employer, worked overseas they are able to claim a deduction in the taxation of a termination payment provided they meet one of the following conditions:
They have spent more than three-quarters of their period of employment working abroad, or
If the period of their service lasted more than 10 years, the whole of the last 10 years was spent working abroad, or
If the period of their service lasted more than 20 years, they had spent more than 10 years of that period working abroad, including any 10 of the last 20 years
If the employee meets any of the above conditions they qualify for a full exemption from UK tax on the payment. Where they do not meet any of the conditions it is also possible to time apportion the exemption.
It is important to understand that termination payments are classed as “specific” earnings for income tax purposes, which means that a person’s tax residence at the time of the payment does not affect the taxation of the payment. For example, if your employee has worked for you for 8 years, the first 3 years in the UK and the remainder in France, he or she will still be liable for tax on any termination payment, even though they left the UK many years ago. These rules will not change.
However, if your employee is a UK tax resident in the year their employment ends they will no longer be entitled to claim a deduction for Foreign Service relief and thus the full payment, subject to the £30,000 exemption, will be taxable in the UK. For example, if your employee has worked for you in Australia for 15 years but spends the last 2 years in the UK, if their employment ends on or before 5 April 2018 he or she will qualify for a full exemption from UK tax on the termination payment. However, it if it ended on 7 April 2018 the full amount will be taxable.
There is still an exemption for Foreign Service as a seafarer but we do not propose to cover this.
Are HMRC also making changes to NICs in April?
No. There were changes announced for NIC purposes also from 6 April 2018 but the Chancellor has decided to defer these until 6 April 2019.
Need further help?
These changes are complicated. If you fail to withhold the correct amount of PAYE, HMRC will pursue you for the under-deduction.
Please contact us on 0870 1500 100 for help and advice.
Published: 22 January 2018
Sign up to receive our monthly employment law update January 2018
For general enquiries
0370 1500 100
Or we can call you back at a time of your choice
Request a call back
Phone lines are open 24/7, 365 days a year