Update – Tax changes to termination payments

Background

Back in the 2016 Budget, the government announced that from April 2018, it would “reform and simplify” the taxation of termination payments. Following a technical consultation, the reforms expanded and now aim to “clarify and tighten” (i.e. increase) the taxation of such payments.

The tax changes came into effect on 6 April 2018 with important implications for employers when negotiating exit payments with employees. The most important changes relate to payments in lieu of notice (PILON) and ‘injury to feelings’ payments.

The old tax regime

Prior to 6 April 2018, the tax treatment of a PILON depended on the contract of employment.

If the contract contained a clause providing the employer with a contractual right to make a PILON, then any PILON made was treated by HMRC as being fully taxable. Therefore, any contractual PILON payment had to be subject to deductions for income tax and national insurance contributions (NICs).

If, however, there was no PILON clause in the contract and the employer had no contractual right to pay an employee in lieu of notice, doing so was generally regarded as a breach of contract. As such, a PILON payment effectively constituted a payment of damages for breach of ontract and could therefore be paid  tax-free up to £30,000. Any amounts in excess of this threshold were subject to tax. There was therefore a tax benefit in making a PILON payment where there was no right to do so in the employee’s contract of employment under the old tax regime.

Key changes under the new regime

From 6 April 2018 onwards, all PILONS are now subject to tax regardless of whether or not there is a PILON clause in the contract of employment. For tax purposes, termination payments are now split into two elements: (1) Post- Employment Notice Pay (PENP), and (2) the remaining balance.

PENP represents the amount of basic pay the employee would have received had their employment been terminated with full and proper notice being served. This element is now subject to income tax and NIC deductions. The legislation sets out a statutory formula to calculate the PENP. Helpfully, detailed guidance and examples have recently been published in HMRC’s Employment Income Manual (https://www.gov.uk/hmrc-internal-manuals/employmentincome-manual/eim12800).

Statutory redundancy payments and elements of a termination payment which do not constitute PENP (or any other contractual entitlement) may still be payable tax-free up to £30,000.

Future changes

Currently termination payments above the £30,000 threshold are subject to deductions for income tax but not NICs. However, from 6 April 2019, all termination payments above £30,000 will also become subject to employers’ NICs. Employees’ NICs will, as is currently the case, not be deducted.

Payments for ‘injury to feelings’

Another important change to the tax treatment of termination payments relates to ‘injury to feelings’ payments made in settlement of claims.

The definition of what constitutes an ‘injury’ changed on 6 April 2018, so that now a psychiatric injury (or other recognised medical condition) is included, and may therefore be compensated tax free, but injury to feelings are expressly excluded. As such, these payments must now be subject to tax. This is in contrast to the previous regime, and in many cases involving discrimination, will substantially increase the taxation on a termination payment.

What does this mean for employers?

Employers currently negotiating termination agreements need to be aware of the changes as they could potentially increase their costs/  impact negatively on settlement negotiations. This is because the value of the overall termination package to the employee will likely be reduced as a result of the changes, and therefore there may be a request to ‘gross up’ the package to account for this.

In cases which are not straightforward, it would be prudent to take legal advice on the implications of the tax changes and the best strategy for managing the situation.

The Employment newsbrief is available in full here.

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