Update on the tax treatment of termination payments

Background

Back in September 2015 we reported on the government’s intention to ‘simplify’ the tax treatment of termination payments which included a proposal to abolish the current £30,000 tax exemption in respect of termination payments.

Since then the consultation period has ended and the government has now produced its response to the consultation together with draft legislation.  The good news is that the £30,000 tax exemption has not been abolished.  However, there is a ‘sting in the tail’ to the legislation with some important changes being made to the taxable treatment of termination payments from April 2018:

  • Termination payments made in excess of £30,000 will be subject to income tax (as previously) but employers will now have to contribute National Insurance Contributions (“NICs”) in respect of any excess in addition.
  • All payments made in lieu of notice “PILON” (whether contractual or not) will be treated as earnings and taxed at the appropriate rate.  NICs from both the employer and employee will also need to be deducted. This previously only applied to contractual PILONs.
  • Foreign service relief (except in relation to seafarers) will be abolished.
  • Payments made for injury to feelings will fall outside the exemption for injury payments, except where the injury amounts to a psychiatric injury or other recognised medical condition.

What does this mean for my business?

The bottom line is that it will become more expensive for employers when making termination payments.  This is because tax and employer NICs will always have to paid on PILON payments.  Additionally, employers will now have to pay tax and NICs on any termination payment made over £30,000.  There may well be circumstances whereby increased financial packages will have to be offered to existing employees to counter the lower net figure which the employee would end up with.

Employers must now calculate how much the employee would contractually have been entitled to had they worked their notice period. This will include any bonus, commission or incentive payments that they would be entitled to had they worked their notice period, as well as any sums which would accrue during the notice period.  If this sum is less than the amount offered as the ‘global’ termination payment, then it will be taxed at the appropriate rate and any excess could become part of the £30,000 exemption.

Example:

The employee earns £100,000 and has a three month notice period.  He does not have a PILON.  This employee would also be entitled to £2,000 worth of benefits during his notice period. The employee would also be due a bonus of £30,000 for performance during the year.

The employer wants to dismiss immediately and comes to an agreement with the employee to pay him £70,000 to terminate the contract.   The tax and national insurance element would be as follows:

  • Any part of the settlement payment which was for redundancy (statutory or enhanced), would be eligible for the £30,000 tax and NI exemption (from both employer and employee)
  • If no part of the settlement payment was for redundancy or an award of compensation for unfair dismissal, it would be taxable as follows:
    • £25,000 PILON would be taxable and subject to NI in full.
    • £2,000 cash equivalent of benefits in kind would be part of the employee’s “post-employment notice income” and so taxable and subject to NI in full.
    • £30,000 bonus would be taxable and subject to NI in full

This would mean that £57,000 of the termination payment would be subject to tax and NI leaving only £13,000 eligible for the £30,000 tax and employer NI exemption and the employee NI exemption. This is potentially a significant reduction in the tax-free amount as compared to the current position, where the full £25,000 would be eligible for the exemptions.

What to do next?

It is essential that employers are aware of these changes and the impact they will have next year.  HMRC continues to scrutinise carefully payments made on the termination of employment.  Such scrutiny may occur years after a payment has been made, in the course of a routine PAYE audit, by which time an employer may have made numerous other payments which were dealt with on the same (possibly faulty) basis. Careful analysis of the nature of a termination payment is crucial before any offer is put forward to an employee as part of a termination package so that both parties are sure as to the net sum that the employee will receive.  

Employers may also wish to consider whether any planned termination should be brought forward in order to benefit from the existing regime which is due to terminate by April 2018.