Notice Pay, Pay in Lieu and Tax
A new tax regime takes effect from 6 April 2018 in relation to payments in lieu of notice (PILONs), alongside other significant changes to the taxation of termination payments. These changes reflect the Government’s stated intention to “tighten and clarify” the income tax treatment of termination payments.
Until now, determining the appropriate tax treatment for payments reflecting notice entitlements has been difficult for employers and fraught with risk. In introducing the new legislation (by the Finance Act (No. 2 2017), the Government has accepted the current tax rules to be complex, and described the current tax exemptions as incentivising employers to manipulate the rules by structuring exit arrangements to include payments which are ordinarily taxable in order to minimise the tax and National Insurance contributions due.
All PILONs to be taxable
Under the new tax regime, all payments in lieu of notice will be treated as earnings for the purposes of income tax and National Insurance liabilities. HMRC has confirmed that these changes will apply where termination payments are made after 6 April and where the employment is ended on or after this date.
The new legislation requires the employer to split a ‘termination award’ between amounts treated as earnings (and so subject to PAYE deductions) and amounts which benefit from the £30,000 exemption as compensation for loss of employment.
The ‘termination award’ broadly means the payment, or other benefit, which the employee receives in return for the termination of their employment. Payments of statutory redundancy are excluded from the scope of the termination award, as are certain other payments and benefits. HMRC guidance has indicated that this will extend to non-statutory redundancy payments (for example under enhanced redundancy schemes).
In order to work out how much of the termination award has to be treated as earnings, the employer then has to calculate the “post-employment notice pay” (PENP). The essential formula for this involves multiplying the employee’s basic pay for the last pay period by the duration of their unworked notice period, and then deducting amounts paid on termination taxable as earnings (other than holiday pay and termination bonuses).
This sounds simple in outline, however there are a number of grey areas in the legislation and complicating factors which can be involved, for example the impact of salary sacrifice arrangements and how to treat termination packages which include exempt contributions into registered pension schemes.
The entire termination award will need to be treated as earnings for tax purposes if it is less than or equal to the PENP figure; otherwise the PENP figure will be the amount taxable as earnings.
The £30,000 threshold for tax-free compensation
From April 2018 HM Treasury will have the power to make regulations which would vary the level of this tax exemption, which has remained at £30,000 since 1988. Watch this space for news of any increase to the threshold.
Injury to feelings payments
From April 2018, payments for injury to feelings (typically made in connection with discrimination claims) will fall outside the tax exemption for injury payments, except where the injury amounts to a psychiatric injury or other recognised medical condition.
Foreign service relief
Foreign service relief for UK resident employees will be abolished from April 2018, on the grounds that the current scheme is outdated and unnecessary. Only employees or former employees not resident in the UK for the tax year in which the employment terminates will be eligible for foreign service relief.
National Insurance liability on termination payments above £30,000
From April 2019 all termination payments above £30,000 will be subject to employer National Insurance contributions (but not employee contributions). This proposal was originally planned for implementation in 2018.
While the new tax legislation will introduce some simplification in this area, there will still be some points of complexity and uncertainty for employers. The overall intention to tighten the tax rules will also in some cases translate into increasing the overall costs of termination packages for exiting employees.