Termination payments rules are changing - what does this mean for HR

HMRC has announced significant changes to how termination payments are calculated and taxed, which will come into effect on 6 April 2018. The impacted areas HR need to be aware of are:

• pay in lieu of notice;
• compensation for injury to feelings;
• contracts of employment; and
• settlement agreements.

Pay in lieu of notice (PILON)

Prior to 6 April 2018, if an employee has no right to PILON in the employment contract, any PILON can be made without deductions of tax and NIC. This meant the employee would get more pay than they would have done had they worked their notice, and the employer would make an NIC saving. The position became a little unclear though if the employer regularly made PILONs, despite there being no PILON clause in the contract of employment, as it could become a contractual term through custom and practice.

From 6 April 2018 though, all PILON will be subject to tax and NIC, even if there is no express PILON clause in the employment contract. Where there is no PILON clause, any payments made to employees which represent the notice the employee should have worked but did not, will be called Post Employment Notice Pay (PENP). There is a special formula for calculating PENP which is covered in our expected reforms to employee termination payments article.

In light of this change, there is now little reason for not having a PILON term in the contract. The benefit of not having one was usually so the employer could immediately terminate the employment and pay the employee in lieu of their notice period without deductions of tax and NIC. As a result, the employee received a greater payment than they would have had they worked their notice, and this can be used as leverage in any exit negotiations. The employer would also have made a saving on employer NIC. The downside to this, though, was that it resulted in other terms of the contract no longer being enforceable - most importantly, the business protection clauses which prevented the exiting employee from poaching customers or key employees, and stealing confidential information.

As a result, employment contracts for new starters should be reviewed and updated to ensure that there is clarity on PILON clauses.

Injury to feelings awards

Compensation for injury to feelings connected to the dismissal (usually arising in discrimination cases) will be subject to the £30,000 tax free cap unless the injury amounts to a psychiatric injury or other recognised medical condition. This has cleared up the conflicting case law that we had on this issue. Where injury to feelings payments are being considered which exceed £30,000, guidance from finance should be sought to establish whether the entire sum can be paid tax free.

Terminations before 6 April 2018

If your contracts of employment do not contain an express PILON clause and you are about to start, or are in the middle of, negotiating an exit with an employee, you might be able to use this change as leverage to negotiate a swifter exit. If the exit takes place on or after 6 April 2018, the employee will lose the enhanced sum and your organisation will have an increased NIC liability.

Settlement agreements

When preparing settlement agreements, it is essential to clearly identify the payments the employee is receiving and what they represent. Instead of bundling a PILON or a PENP within a termination payment, these should be separated out into their respective elements. This will avoid confusion over what the payments represent and disputes from HMRC as to their taxable status.

Template settlement agreements should therefore be updated to categorise the payments the employee will be receiving on termination.

Actions for HR to take

• Ensure employment contracts are updated to give clarity on PILON payments for new starters.
• Update settlement agreements to make clear what payments the employee will be receiving and what they represent.
• Seek guidance from payroll or finance on calculating PENP early on in any exit negotiations so you accurately communicate to the employee the sums they will be receiving and what the exit costs for the business will be.
• Consider whether the change could be used as a negotiating tool to speed up current or imminent exit discussions so that the termination date is no later than 5 April 2018.

On a practical basis, HR advice has usually been to treat any PILON payment, whether contractual or not, as subject to tax and NIC to avoid any later penalties. This latest change by HMRC provides clearer guidance to HR professionals when dealing with unclear contracts of employment.

If you need support in conducting a detailed and practical audit of your employment contracts, or assistance in understanding the changes please contact Kerri Constable, Charlie Barnes or your usual RSM contact.

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