Changes to taxation of termination payments came into force in the United Kingdom on 6 April 2018. The new rules will mean that income tax and national insurance contributions (NICs) will be payable on all payments which relate to an employee’s notice period.
The position prior to 6 April was that a “termination payment” (being any payment that is not already chargeable to income tax) could be paid tax free up to £30,000. However, any payments made pursuant to the contract of employment including a contractual payment in lieu of notice (PILON) would be subject to tax in the usual way. One particular area of issue was the taxation of discretionary PILONs. Whilst a discretionary PILON may be outside the contract and therefore could arguably fall within a true termination payment, where such a payment has become “customary” then the UK tax authority (HMRC) has sought to tax that non-contractual PILON.
Changes to payment from 6 April 2018
As an attempt to simplify the position, the new rules mean that all PILONs will be taxed as earnings. Employers will be required to calculate “post-employment notice pay” (PENP) which will represent the amount of basic pay an employee would have received if they had worked their notice in full. The PENP will be taxable as earnings and will be subject to income tax and NICs. Termination payments exceeding any PENP payment will continue to benefit from the £30,000 exemption.
Calculating post-employment notice pay
It is wrong to assume that all PILONs will therefore now be taxed in the usual way. Employers will need to understand how to calculate PENP to determine how the termination payment will be taxed. In calculating “Basic Pay” an employer must take into account the employee’s taxable employment income in the final pay period, but disregarding amounts including overtime, bonus, commission, gratuity or allowances. One key point to note is that in determining the amount of PENP the basic pay will be based on notional pay prior to any amounts that the employee has given up by way of salary sacrifice.
The legislation specifies that the new rules relate to payments made after 5 April 2018. HMRC has given guidance that states that the change in tax status will apply only if both the termination payment and the employment terminated after that date.
From April 2018, a payment on termination for ‘injury to feelings’ will not fall within the exemption from tax and NICs for payments made because of death, disability or injury. This change is being introduced in response to recent conflicting case law. The exemption will only apply where is an injury or disability of a physical or psychological nature that is sufficient to cause the employee to be unable to perform his or her job properly.
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. If the employee is a UK tax resident in the year the 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.
There were changes announced for NIC purposes also from 6 April 2018 but the Government has deferred these until 6 April 2019. From April 2019 any excess over £30,000 will be subject to employer’s (but not employee’s) NICs.
As a result of these changes employers may see employees trying to negotiate higher termination payments in order to compensate for the amounts they will lose. In addition in view of the loss of the potential tax advantage there is little benefit in not including a PILON clause in a contract of employment. Whilst employers have often included these in all senior service agreements we may see their inclusion in all new contracts.