It was in 2014 when the Office of Tax Simplification reported the need to reform the treatment of termination payments. It’s been a long time coming and, what started out as a recommendation for the simplification of the process, has turned into an opportunity to increase both the tax and national insurance contributions (NIC) yield.
When considering the tax treatment of a payment in relation to a termination of employment, it cannot be assumed that the £30,000 ‘termination payment exemption’ applies. You must always break the payment down into its constituent parts and review each one individually. For each part, you must consider if it is taxable as earnings or under some other provision and, if so, you must put it through the payroll to charge it to both income tax and class 1 NIC. Examples of such taxable payments on termination include:
- contractual payment in lieu of notice (PILON);
- payment for a restrictive undertaking;
- payment on retirement; and
- release of a loan.
If it is not earnings or taxable under any other provisions, you must then consider if it must be taxed as a termination payment, with the first £30,000 being exempt. There is no corresponding NIC charge on such termination payments. It is the treatment of these termination payments that is changing and that is the focus of this article.
Post-employment notice pay
The new legislation seeks to bring a uniform approach to the treatment of PILONs. Currently, where the employment contract provides for a PILON to be made, this is treated as earnings and charged to income tax and class 1 NIC. On the other hand, where there is no provision for a PILON, these payments are often treated as termination payments, meaning they are not charged to NIC and are tax exempt within the available £30,000 limit. This means that you can currently have two employees with fundamentally identical termination packages, but with very different net payments.
Going forward, there is to be a formulaic calculation of post-employment notice pay (PENP). This is equal to the employee’s basic pay before any salary sacrifice, over the period for which they are legally or contractually entitled to receive notice. The basic pay calculation excludes overtime, bonus, commission, benefits and share based earnings.
If the termination payment is no more than the PENP, then it is all treated as earnings and charged to income tax, along with both employee and employer NIC. If the termination payment is more than the PENP, the excess is treated as qualifying for the £30,000 exemption, with the PENP amount treated as earnings.
Broadly, the intention of the new legislation is to tax as earnings the basic pay that the employee would have earned, had they worked their notice.
NIC on termination payments in excess of £30,000
The charge on termination payments in excess of £30,000 is currently limited to income tax. The new legislation will ensure that any termination payment in excess of £30,000, that is chargeable to income tax, will also attract a class 1A NIC liability. Charging it to class 1A NIC rather than class 1 means that only the employer will suffer NIC and not the employee. Until now, employers have associated class 1A NIC only with benefits reportable on form P11D and class 1A NIC has been payable by 6 July after the tax year end. However, this new type of class 1A NIC is expected to be payable under real time information.
Payments for injury to feelings
Where a payment is made in connection with the termination of an employment on account of death, injury or disability of the employee, the payment can in some circumstances be fully exempt from charge to both income tax and NIC. The new legislation ensures that payments for injury to feelings connected with the termination will fall outside this exemption, except where the injury amounts to a psychiatric injury or other recognised medical condition.
Download the full report for our recommendations to prepare ahead of these changes.