Charlotte Sloan, Senior Associate at Irwin Mitchell’s employment team explains what employers and employees need to know about the changes to tax and employee termination payments
The tax treatment of some termination payments is changing. From 6 April 2018, new rules apply to payments made to employees in lieu of them working out their notice period. Typically such payments are made in the context of an employer and an employee agreeing terms for an employee’s amicable departure under a settlement agreement.
Over the last couple of years, HMRC has been consulting on changes to the tax and National Insurance Contribution (NIC) treatment of termination payments made to employees at the end of their employment. Usually such payments are made as an incentive for the employee to agree to waive any employment claims they may have against their employer and to secure both parties agreement to an amicable employee departure under the terms of a settlement agreement.
HMRC’s aim has been to simplify what it sees as unnecessarily complex rules and exemptions that incentivise employers to manipulate the rules by structuring arrangements to minimise the tax and NICs due.
The taxation of notice pay (where the employee does not work their notice) depends largely on whether there is a payment in lieu of notice clause (a PILON clause) in the employee’s contract of employment. A PILON clause is a clause which contractually gives the employer the right to terminate an employee’s employment without the employee needing to work out their notice period, by making a payment equivalent to their notice pay. Where there is a PILON clause the notice payment is a contractual payment and therefore needs to be subject to tax and NICs. There are also some other circumstances where notice pay needs to be subject tax, including where a PILON clause is deemed to be implied into the employee’s contract through custom and practice.
However, certain payments can be made without tax deductions. In particular, it is usually possible upon termination of an employee’s employment to make a payment by way of compensation for loss of employment without deduction of tax up to a maximum of £30,000. Further where an employee’s employment contract does not contain a PILON clause and an employer makes a payment in lieu of notice then this can be paid without tax deductions subject to the £30,000 overall cap. This is because as there is no contractual entitlement to pay in lieu of notice the employer, by making such a payment, is technically breaching the employee’s contract and the payment is therefore treated as compensation for loss of employment rather than a contractual payment.
HMRC has criticised this system where some payments in lieu of notice are subject to tax and others are not, largely dependent upon whether there is a PILON clause in the contract, as unduly complex and sought to address this through law reform.
What is changing?
For employees whose employment is terminated after 5 April 2018, payments in respect of notice pay where there is a PILON clause will continue to be taxable in full.
However, in addition, payments made in respect of notice pay where there is no PILON clause will be subject to tax deductions and NICs.
Under the new regime all payments made in respect of notice pay have been re-categorised as “post-employment notice pay”. As a result an employee will no longer be able to be paid a tax-free sum equivalent to basic notice pay within the £30,000 tax-free exemption, even in circumstances where there is no PILON clause in the employee’s contract.
How does this affect employers and employees?
Employers will need to tax all “post-employment notice pay”. This essentially means that employees may receive a reduced sum for notice pay than they would have under the current regime as any notice pay sum they receive will be a net amount. An employer negotiating a settlement arrangement deal with an employee will no longer be able to offer the additional incentive of tax-free notice pay where there is no contractual PILON.
HMRC have introduced a complex statutory formula to calculate the amount of tax due in respect of “post-employment notice pay” which employers need to apply where notice is not being worked.
Settlement agreements going forward will need to include appropriately worded clauses to reflect the fact that the appropriate tax and statutory formula have been applied in relation to notice payments.
The good news is that employers and employees will still continue to benefit from the tax exemption permitting statutory redundancy payments and genuine payments for loss of employment to be paid tax-free up to £30,000, provided there is no disguised notice pay included in such payment.
However, the changes in respect of the taxation of notice pay will increase the tax liability on many termination payments and despite HMRCs intention to simplify the regime, in our view, add further complexity.
When do these changes come into effect?
The new rules apply where both the payment and the termination date of employment take place on or after 6 April 2018. Accordingly, if employers and employees alike want to avoid being caught by the new rules and take advantage of the current more generous tax exemption rules in respect of notice pay where there is no PILON clause they must act quickly.
For further help on this issue and any other employment issue, please contact Charlotte Sloan by emailing firstname.lastname@example.org or call 01293 742959.