The government is set to introduce a series of reforms to the tax and National Insurance Contributions ('NIC') treatment of termination payments. Although the background to these reforms is simplification, some of the changes are far from simple and often result in increased tax and NIC liabilities being payable on termination packages.
- What are termination payments?
- What is changing?
- What is Post-Employment Notice Pay?
- Have HMRC published guidance on these changes?
- What should employers do?
We are referring here to payments made by employers to employees (or former employees) on the termination of their employment. Examples include accrued holiday pay, payments in lieu of notice, redundancy pay, injury payments, compensation, and damages payments for breach of contract.
For tax and NIC purposes, where payments are made to an employee on the termination of employment, the exact nature of the payments, and the circumstances resulting in those payments being made, must be properly considered. The following questions should then be asked in respect of each payment (or the component parts of the total payment) to determine the correct tax and NIC treatment.
- Do the rules in relation to receipts from non-approved and employer-financed retirement benefits schemes apply to the payment? If so, the special rules for such payments must be applied.
- If 1 does not apply, does the payment fall within the category of general earnings and is it taxable under the normal rules for earnings from the employment?
- If 2 does not apply, is the payment made in return for the employee entering into a restrictive undertaking, and if so is the payment taxable and liable to NIC as a restrictive covenant?
- If 3 does not apply, and no other income tax charge or exemption applies to the payment, for tax and NIC purposes the payment is treated as being made in connection with the termination of employment. Special rules then mean that the first £30,000 of the total payments and benefits qualifying for this treatment are exempt from tax and there is no NIC payable. In some cases, for example where a payment is in respect of disability, a payment may be completely exempt from tax.
While the step-by-step approach outlined above will still apply, the tax and NIC reforms will clarify and 'tighten up' the rules in several areas.
Initially, from 6 April 2018:
- The concept of Post-Employment Notice Pay (PENP) will be introduced. This will treat all payments in lieu of notice as earnings subject to tax and Class 1 NIC under PAYE, irrespective of whether those payments are contractual or customary.
- Foreign service relief (except in relation to seafarers) will be abolished for employees who are UK tax residents in the tax year their employment terminates. This will affect the tax and NIC treatment of termination payments made to employees who have spent significant periods of their employment abroad, but who are UK residents at the time their employment ceases.
- A legislative change will ensure that payments for injury to feelings (except where the injury amounts to a psychiatric injury or other recognised medical condition) will fall outside the full exemption for disability and injury payments provided by Section 406 ITEPA 2003. Injury payments which qualify for this exemption are completely exempt from tax and NIC.
- New legislation will be introduced which will allow the Treasury to vary the £30,000 threshold by regulations. Hopefully, we will only see the threshold increase if it is varied.
Then, from 6 April 2019 all termination payments above the £30,000 (unless it is varied) threshold will be subject to employer’s Class 1A NIC (but not employee Class 1 NIC) in addition to tax. This will significantly increase the NIC cost for employers of larger termination payments.
HMRC have confirmed that it is the date the employment contract ends which determines whether the new rules from 6 April 2018 apply. For example, if the termination of employment takes place before 6 April 2018, but the termination payment is made on or after 6 April 2018, provided the contract of employment ends before 6 April 2018 the current rules to 5 April 2018 will apply to the termination payment. With regard to the foreign service relief rules, however, the new rules will only apply where the termination payment is also made on or after 13 September 2017 (which is likely in most cases).
The change which is attracting the most attention is the introduction of PENP.
The intention of this reform is to treat the basic pay an employee would have received had they worked their notice period as normal earnings. The tax and NIC treatment of payments in lieu of notice will therefore no longer depend on whether a contractual payment in lieu of notice is made, or whether payments in lieu of notice are made under a custom or practice established by the employer.
Instead employers must identify the part of the overall termination award which represents basic pay for any part of a notice period that is not served or worked. This is the PENP.
Once identified the PENP is compared with the entire termination award and the part of the termination award that must be treated as normal earnings for tax and Class 1 NIC purposes is:
- the entire termination award (but disregarding statutory redundancy pay and approved contractual pay) if the PENP is equal to or more than the termination award; or
- the PENP if it is less than the termination award.
The calculation of the PENP is based on a formula which depends on the employee’s circumstances. The basic PENP formula for an employee who is paid monthly, whose contractual notice period is expressed in months, and whose unworked period of notice is a whole number of months is BP x D – T, where:
- BP is basic pay for the last pay period to end before the day notice is given. Basic pay is defined in the legislation.
- D is the number of months in the post-employment notice period. This period starts with the end of the employment and ends with the earliest lawful termination date. The earliest lawful termination date starts when notice is given and is equal to the minimum statutory notice the employer must give to terminate the employee’s employment.
- T represents amounts (other than holiday pay and termination bonuses) which are paid on termination but which are already taxable as earnings. This is to ensure that such amounts are not taxed and subjected to NIC twice.
An employee has worked for her employer for one year, is paid £5,000 monthly, and has a three-month notice period. She hands in her notice on 1 May 2018. She works one month of her notice period and then her employment is terminated. Her employer makes an ex-gratia termination award of £12,000. There is no contractual or customary right to a PILON.
The PENP = BP (£5,000) x D (2 months) – T (nil) = £10,000.
As the PENP is less than the termination award of £12,000, £10,000 is treated as earnings (liable to tax and Class 1 NIC) and the balance of £2,000 can be paid free of tax and NIC.
Prior to 6 April 2018, the whole amount could be paid free of tax and NIC.
The calculation and comparison becomes more complicated where statutory redundancy pay is due.
An employee is 45 years old and has worked for his employer for 15 years. He is paid £4,000 monthly and has a three-month notice period. He is made redundant and he works two months of his three-month notice period before his employment comes to an end on 31 August 2018. His employer makes an enhanced redundancy payment of £12,000 to him which includes statutory redundancy pay of £8,300. There is no contractual or customary right to a PILON.
The PENP = BP (£4,000) x D (1 month) – T (nil) = £4,000.
As the PENP is more than the termination award of £3,700 (the statutory redundancy payment of £8,300 is ignored in the comparison), £3,700 is treated as earnings (liable to tax and Class 1 NIC) and the balance of £8,300 can be paid free of tax and NIC.
Prior to 6 April 2018, the whole amount could be paid free of tax and NIC.
For terminations after 6 April 2019 the employer NIC cost for total qualifying termination payments which exceed the £30,000 will increase. In addition, the position can become more complicated with part of the termination award being liable to tax and employee’s and employer’s Class 1 NIC, part being exempt from tax and NIC, and part being taxable and liable to employer’s Class 1A NIC.
An employee has worked for an employer for 16 years. He spent the first 14 years of his employment working solely in the USA and was not resident in the UK during this period. He returned to the UK approximately two years ago and has been resident in the UK since then. The employee has a notice period of three months and is paid £7,000 per month.
On 1 June 2019 the employee and his employer mutually agree that his employment cannot continue. The employee works one month of his notice period and his employment ceases on 30 June 2019. His employer makes an ex-gratia compensation payment for loss of employment to him totalling £75,000. There is no contractual or customary right to a PILON.
The PENP = BP (£7,000) x D (2 months) – T (nil) = £14,000.
As the PENP is less than the termination award of £75,000, £14,000 is treated as earnings (liable to tax and Class 1 NIC). Of the balance of £61,000, £30,000 is exempt from tax and NIC, and £31,000 is liable to tax and employer’s Class 1A NIC.
Prior to 6 April 2018, the whole amount could be paid tax and NIC free because three fourths of the employee’s service is foreign service.
The big concern at the time of writing this newsletter is that, despite these changes being less than a month away, HMRC have still not published detailed practical guidance on these changes.
This absence of practical HMRC guidance is creating several areas of uncertainty. For example, it is currently unclear whether it is necessary to carry out the PENP calculation where a contractual PILON is paid. Furthermore, what should happen with the PENP in gross misconduct cases where there has been a dispute over whether notice should have been served and both parties ultimately reach a settlement.
All employers should familiarise themselves with and prepare for these expected changes, and ensure that the correct tax and NIC treatment is being considered and applied to termination awards going forward.
Employers will face practical challenges when applying these new rules. These practical challenges are explored in more detail in our Employment Matters Hub.
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