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UK HR E-briefing: Don’t overlook April’s changes to tax and termination payments

  • United Kingdom
  • Employment law - HR E-Brief

05-03-2018

Changes to the tax treatment of termination payments from 6 April 2018

Significant changes to the tax treatment of termination payments are being implemented on 6 April 2018. Broadly speaking, these changes remove the differing tax treatment that currently applies to contractual and non-contractual payments in lieu of notice (PILONs).

Whilst payroll practices and software will need to be adapted to take into account the new calculations of tax liability on termination, one significant impact of which both employers and employees need to be aware is that the previous practice of paying notice pay of under £30,000 as a tax free damages payment (in lieu of requiring the employee to work their notice in accordance with their contract) is no longer possible. Under the new provisions, the tax treatment of payments on termination of employment no longer depends on whether there is a contractual PILON in the contract.

Aside from a potentially increased tax liability, in the short term employers should also be prepared to manage the expectations of departing employees who might have expected a greater tax free lump sum on leaving.

Summarised below, through a series of questions and answers, are key aspects of the new regime.

Q: What are the main differences between the old and new taxation provisions from April?

A: The principal differences between the old and new regimes are:

  • the differing tax treatments of contractual and non-contractual PILONs are effectively removed;
  • the legislation re-characterises any termination payment received by an employee as fully taxable to the extent they have not worked their full notice period.

NB contractual PILONS remain fully taxable and are unaffected by these changes.

Q: When do the changes take effect?

A: The changes to the tax treatment of termination payments take effect where the termination date is on or after 6 April 2018. HMRC has stated that where the contract of employment ends before 6 April 2018, the old rules for termination payments will apply, even where a payment is made on or after 6 April 2018.

(NB Looking ahead, termination payments which benefit from the £30,000 exemption in principle but are in excess of £30,000 will also attract employer NICs from 2019).

 Q: How is the tax/NI liability for unworked notice calculated?

A: As referred to above, where there is no contractual PILON and there is a period of unworked notice an element of the termination payment will be re-characterised and subjected to income tax and class 1 NICs. How much of the termination payment will be re-characterised in this way is determined by calculating what is referred to as “post-employment notice pay” or “PENP” ie pay for any unworked days of notice and then comparing this figure against the termination payment which the employee receives which is not otherwise taxable.

The essential aim of calculating PENP is to identify a daily rate of pay for the unworked period of notice, which can then be accounted for for tax purposes. Having done this, the new approach provides that, if the termination payment is less than PENP then the whole of the termination payment will be re-characterised and will be fully taxable and subject to NICs. Conversely, if the termination payment is greater than PENP then the amount of the termination payment equal to PENP will be re-characterised and will be fully taxable and subject to NICs. The balance of the termination payment will be taxed as follows:

  • the first £30,000 may be paid tax free;
  • any excess will be subject to income tax (and from 6 April 2019 employer’s NICs).

Q: How to work out PENP?

A: PENP is calculated by reference to the following formula:

(Basic Pay x Unworked Days) ÷ Monthly pay (or other relevant pay period) - Taxable elements of the termination payment

This is best illustrated by a worked example:

e.g. if the facts are as follows:

  • there is no contractual PILON;
  • the employee is entitled to 3 months’ notice;
  • the employee does not work any of the notice period;
  • the employee is paid monthly;
  • the employee’s basic pay prior to the termination date was £5,000 per month;
  • the employee is paid £55,000 as a termination payment.

PENP will be £15,000 ((£5,000 x 3)/1) – 0) and the termination payment will be taxed as follows:

  • £15,000 – subject to income tax and NICs;
  • £30,000 – paid tax free; and
  • £10,000 – subject to income tax only.

Q: What is “Basic Pay” for the purposes of calculating the PENP?

A: Basic pay has a statutory definition and includes all employment income other than overtime, bonus, commission, gratuities and allowances and amounts treated as earnings including amounts under the benefits code and relating to securities. Basic pay will also include any amount which the employee has surrendered pursuant to a salary sacrifice arrangement e.g. in return for pension contributions, childcare vouchers, etc. Any such deducted sums will need to be added back to basic pay in order to calculate the correct PENP figure.

It is the employee’s basic pay in the last pay period prior to termination or the service of notice that is required for the purposes of calculating PENP. If the employee is paid monthly this will therefore be the employee’s basic pay in the relevant month ending prior to the service of notice or the termination date.

Q: When calculating PENP what parts of the employee’s termination package can be deducted?

A: For the purposes of calculating PENP, the taxable termination pay elements that need to be deducted will not include pay in respect of pre-termination holiday entitlement or any ex-gratia payment on termination of employment. The former will be fully taxable in its own right and therefore falls outside the calculations for current purposes; the latter will be included in the amount tested against PENP but not in the calculation of PENP. Any contractual payment in lieu of notice (which will be fully taxable by its nature) will be included in the amount to be deducted and therefore reduce the amount of PENP (in accordance with the formula above).

Q: What elements of the termination package are not tested against PENP?

Certain categories of payment are expressly excluded from re-characterisation and therefore will always qualify for the £30,000 tax exemption. These are:

  • statutory redundancy payments;
  • an “approved payment” under s157 ERA (in so far as it is equal to or less than a statutory equivalent).

Q: Are there any changes employers should consider making to their contracts?

A: Since the tax advantages of not including a PILON clause are almost entirely removed by the new provisions, employers may well wish to reconsider adding such clauses to protect any contractual terms intended to survive termination e.g. restrictive covenants.

Employers should also check that any existing PILON clause wording refers to basic pay only. If it does not, the additional amount received by the employee under the PILON clause in lieu of the contractual payments and benefits the employee receives each month, will be fully taxable under general tax principles and not due to it being re-characterised. As such no amount of such payment will benefit from the £30,000 exemption. In contrast, the equivalent overall termination package provided in the absence of a PILON clause may then be more tax efficient, since the amount re-characterised in that scenario is only by reference to basic pay (i.e. PENP is calculated by reference to basic pay) with the remainder (including any amount in lieu of benefits) potentially benefiting from the £30,000 exemption.

Comment

Conceptually at least, the background to the new provisions was to simply the tax treatment of termination pay and remove some of the uncertainty over access to the £30,000 exemption for non-contractual payments. Whilst a move towards standardising the taxation of contractual and non-contractual payments might have achieved that, even before their implementation, the new provisions have been criticised as overly complex. In the short term, therefore, many employers and employees could well be less certain of tax liability, not more so, until they become more proficient at undertaking the calculation we have outlined above. In the longer term, we expect increased incidence of contractual PILONS and fully taxed notice pay.

As we have alluded to above, another important aspect for employers will be communication of the changes to staff, particularly those who will be leaving employment after April 2018 but will have held an expectation of a tax free lump sum payment in lieu of notice.

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