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Changes to the termination payments legislation

  • United Kingdom
  • Employment law
  • Tax planning and consultancy

06-10-2017

Background

Draft legislation, which alters the way termination awards are taxed, has been published in the Finance (No.2) Bill 2017. The draft legislation, which is the result of a process of consultation, has the broad aim of simplifying the taxation of termination payments and in particular removing the differing tax treatment which currently applies to contractual and non-contractual payments in lieu of notice (PILON).

Current position in relation to PILONs

As the law currently stands contractual PILONs (i.e. payments pursuant to a PILON clause in the employment documentation) are treated as fully taxable earnings from employment and are therefore subject to deductions for income tax and National Insurance contributions (NICs) via the PAYE system.

Where a payment is instead made on the termination of employment as damages for failure to provide an employee with their notice entitlement (as a result of there being no contractual right to terminate and pay in lieu) then such a payment will fall to be taxed under sections 401-403 Income Tax (Earnings and Pensions) Act 2003 (ITEPA) and will therefore benefit from the £30,000 exemption (to the extent this is still available) that applies to termination payments. Only the amount in excess of £30,000 will be subject to income tax but no NICs will be payable in respect of the entire amount (irrespective of whether the amount exceeds the £30,000 threshold).

HMRC have also developed a practice in relation to what is commonly referred to as ‘auto-PILONs’ (broadly PILONs made as an automatic response to termination but not pursuant to an express contractual right) with such payments also being fully taxable and subject to NICs (as with contractual PILONs).

The application of the current legislation and practice has evolved such that the tax treatment of the various types of PILON payment can at times be uncertain and unfair.

Effect of the new legislation

Although the way in which the new legislation is drafted is complicated, the principle which underpins its operation is reasonably straight-forward. Namely, to the extent an individual does not work their full notice period and receives a termination payment, that termination payment will be (wholly or partly) re-characterised as a fully taxable and NICable notice payment.

This is achieved by calculating the employee’s ‘post-employment notice pay’ (PENP), which is effectively an amount equivalent to the employee’s basic pay for any period of unworked notice. Basic pay for this purpose will be based on the basic pay for the last pay period prior to the termination although importantly it also includes amounts which an employee has given up the right to receive under salary sacrifice arrangements. Credit is also given (in the form of a deduction in the calculation of PENP) for any contractual PILON that is paid (effectively avoiding double counting). Once PENP has been calculated, the legislation re-characterises an equivalent amount of the employee’s termination payment as a fully taxable notice payment.

As a result, only the amount of the termination award in excess of the employee’s PENP (or nothing if the termination award is less than PENP) will be taxed under sections 401-403 ITEPA and therefore benefit from the £30,000 exemption.

The only termination payments which are specifically carved out of this re-characterisation mechanism (and which are therefore not tested against PENP and continue to benefit from the £30,000 exemption) are redundancy payments under Part 11 of the Employment Rights Act 1996 and ‘approved contractual payments’ (being payments under an agreement in respect of which an order is in force under section 157 of the Employment Rights Act 1996). Based on the current draft legislation, enhanced redundancy payments will therefore not necessarily benefit from the £30,000 exemption and will be included in the amount tested against PENP. This represents a change in position as currently both statutory and enhanced redundancy payments are taxed as termination payments under sections 401-403 ITEPA and therefore potentially benefit from the £30,000 exemption.

Wider implications

As a result of the new legislation the potential tax benefit of not including a contractual PILON clause within an employee’s employment documentation (i.e. to allow notice payments to be paid as tax free damages payments subject to the £30,000 exemption) has been removed since all payments in lieu of notice (whether contractual or otherwise) will be treated as fully taxable.

These changes may well encourage inclusion of a contractual PILON clause in the majority of new contracts going forwards to allow employers to lawfully terminate an employee’s contract without notice and preserve the benefit of any restrictive covenants which would otherwise have lapsed in the event of an unlawful termination.

Other related legislative changes

In addition to the above changes it is also expected that post-April 2018, employer NICs will be payable on the elements of a termination payment exceeding £30,000 (although the full amount of such payments will continue to escape liability to employee’s national insurance).

Draft legislation has also been published for inclusion in the Finance Bill 2018 which has the effect of abolishing foreign service relief for employees that are UK tax resident in the tax year that their employment terminates. Foreign service relief can apply to provide complete or partial exemption from tax on termination payments to reflect periods of foreign service in an employee’s employment history with an employer. As drafted the legislation would only make foreign service relief available to an employee in circumstances where the employee is non-UK tax resident in the tax year that their employment terminates (and will be viewed by many as a welcome concession by the Government following their original intention to abolish foreign service relief in its entirety).

When does the new legislation take effect?

The changes to the termination legislation (and the imposition of employer NICs on payments in excess of the £30,000 threshold) are to have effect from 6 April 2018.

The changes to foreign service relief are to have effect in relation terminations on or after 6 April 2018 and where the payment or benefit in question is received after 13 September 2017.

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