Changes to taxation of termination payments
Where employment has ended and a termination payment is made on or after 6 April 2018, the Finance (No. 2) Act 2017 inserts new provisions into the Income Tax (Earnings and Pensions) Act 2003 for calculating the tax due on the payment. Whilst the legislation was passed last year, HMRC has only just updated its guidance to help with some of the many unanswered questions and anomalies arising from the new provisions.
Although the legislation is aimed at taxing all payments in lieu of notice (PILONs) as earnings (tax and NIC), the method by which this is achieved is complicated and leads to anomalies which employers should look out for. Each termination payment made on or after 6 April 2018 (providing employment also ended on or after 6 April) must go through a specific calculation process, whether or not there is a contractual PILON to be paid. This will affect both the amount payable and the terms of settlement agreements and severance negotiations.
Which termination payments are affected?
All termination payments are potentially affected. Whilst in some cases the net result might be that no tax is payable due to the circumstances and nature of payment, best practice is for employers to carry out the calculation to ensure that an amount which should have been subjected to PAYE and NICs is not missed.
The basic principle is that termination payments are now split into 2 elements:
- "Post-employment notice pay", determined according to a statutory formula, on which tax and NICs will be payable; and
- Relevant Termination Awards above this amount, which can still benefit from the £30,000 tax exemption. Relevant Termination Awards are the global figure for all termination amounts (except those already taxable as earnings, such as contractual PILONs) paid to the employee, excluding statutory redundancy pay and "approved contractual payments". (Such "approved contractual payments" are likely to be very rare in practice, but would include, for example, payments where there is a collectively-agreed contracting out from the statutory redundancy payment regime which has been specifically approved by the Government).
What is the formula to be used?
The formula depends on a number of factors. In essence it:
- Brings in almost all termination payments;
- Then works out any unworked notice period (based on the notice the employer must give the employee, even if the notice period required of the employee under the contract or in law is shorter and they resigned); and
- Then deducts termination payments that are either already taxable elsewhere or are not taxable.
The basic formula is:
Usually the above will be calculated using a formula based on days. In other cases, the formula is based on whole months, which makes the calculation much easier. The monthly formula may be used where:
- The employee is paid monthly and the last pay period before the end of employment or the day notice was given (whichever comes first) was a whole month; and
- The notice required to be given by the employer is expressed in the contract as a whole number of months; and
- The post-employment notice period (i.e. 'D' – see further below) is the same as the employer's minimum notice or is a whole period of months.
BP (Basic Pay) is the basic pay received for the last pay period (weekly, fortnightly, monthly or however regularly the employee is paid) which ended before the last day of employment or the date notice was given (whether by employer or employee, and whether fully worked or not), whichever comes first. Basic Pay includes employment income but does not include any:
- Amount received in connection with the termination of employment
- Amounts treated as earnings under the benefits code or certain other provisions (e.g. restrictive covenant payments)
- Income related to securities and securities options or employment-related securities that constitute earnings.
However it does include any amounts deducted by way of salary sacrifice. This means basic pay is increased to what it would have been if no salary sacrifice arrangement was in place.
D (Post-employment notice period) means the period beginning with the last day of employment and ending with the earliest lawful termination date. The earliest lawful termination date is based on the notice the employer has to give to the employee by law or contract, regardless of whether it was the employee who resigned or whether the employee has a different notice period. For the daily formula, this period is the number of days. Where the monthly formula can be used, D is this period expressed in months. If the earliest lawful termination date is or precedes the last day of employment, then D will be nil.
P (Length of the pay period) will either be the number of days in the employee's last pay period (so, the period of the last regular payment before the end of employment or notice was given as per Basic Pay above) or, if the monthly formula can be used, P will be 1 (which effectively means you can leave out P altogether).
T (Termination payments taxed as earnings) means the total of the amounts of any payment or benefit received in connection with the termination of employment and which has already been taxed as earnings. This will include contractual PILONs or auto-PILONs which are always taxed as earnings. These amounts are deducted in the basic formula to avoid double taxation. However T doesn’t include pay for untaken holiday or a termination bonus.
There are separate provisions catering for scenarios where there has not been any full pay period yet or where there is a fixed-term contract with no contractual notice period. There are also anti-avoidance provisions to ensure employers and employees do not seek to make arrangements to get around the new taxation provisions.
Once you have calculated the formula, you will be left with an amount representing "post-employment notice pay" (the "PENP"). The PENP figure is then measured against the Relevant Termination Award (see above).
If the PENP is equal to or more than the Relevant Termination Award, the entire Relevant Termination Award is taxable as earnings. If the PENP is less than the amount the employee receives as a Relevant Termination Award, but not nil, the PENP figure is taxable as earnings. The balance of the Relevant Termination Award which has not been taxed under the PENP is then available for inclusion within the £30,000 tax exemption which employers will be familiar with.
By way of example of the workings of this new regime, the following illustrates its application:
An employee earns £10,000 a month and has a 12 week notice period. The employer exercises its contractual right to terminate the employment without notice and pays a contractual PILON equal to 12 weeks' salary. The employer makes an additional payment of £5,000 which is a Relevant Termination Award.
D: 84 days (12 weeks expressed in days)
P: 30 days (the length of the previous pay period if it was a 30-day month)
T: (based on the more precise 52.1 weeks in the year – many employers would simply use 52 weeks)
The amount of £361 is less than £5,000 (the Relevant Termination Award), so £361 is the Post Employment Notice Pay amount which must be subjected to PAYE and NICs. The £27,639 contractual PILON will also be subjected to PAYE and NICs as earnings just as it would have been in the previous regime (because it is contractual). The balance of the £5,000 in excess of £361 can benefit from the £30,000 tax exemption.
What do employers need to be aware of?
Unfortunately there is no easy way out of using the statutory calculation. It is likely that payroll providers will provide automatic programmes to calculate the formula, but employers still need to be able to provide information, such as whether there is a contractual notice period expressed in months and other information to determine whether the monthly formula may be used, what the employer's contractual notice period is (even if it is the employee who resigned), what the various elements of termination payments represent and whether salary sacrifice is involved.
There are some anomalies arising from the way the calculation is applied. Employers will note that in some cases more tax is due than in circumstances where a PENP calculation had not been carried out. This is particularly evident in the formula which uses the daily form of the calculation where, depending on the number of days in the last pay period, the result of the PENP calculation can vary. Other circumstances to watch out for are where, for example, an employee resigns using a shorter notice period than the notice the employer is required to give, or an employee resigns without notice in what could amount to constructive dismissal circumstances. Compensation payments in these cases could be reduced by additional tax payable. There is also currently a question mark over cases of gross misconduct where an employer is not required to give any notice by law, but any compensation payment subsequently made to an employee may still be subject to the full employer's notice period, with the post-employment notice pay element still being taxable. This is yet to be clarified by HMRC.
Where these anomalies do occur and the results of the PENP calculation lead to an increased tax liability, employers are advised to deduct the higher amount to avoid interest and penalties being imposed by HMRC. Tax indemnities in settlement agreements are notoriously difficult to enforce but employers may be able to claim the overpaid tax back from HMRC or (failing that) through a tax indemnity. Settlement agreements will need to be revised to account for the new provisions to ensure that tax is being dealt with properly in the agreement. If the calculation is not set out either in the agreement or separately, employers may well get tax-related questions from an employee's solicitor advising on a settlement agreement or may be asked to remove tax indemnities. Evidence of having carried out the correct calculation will be helpful if HMRC subsequently queries the tax treatment of a termination payment.
The new regime also means that it will usually now be advisable to have a well-drafted PILON clause in all contracts of employment, because there is unlikely to be a tax advantage in not having one.
If you would like help or further information on any of these issues, please do not hesitate to contact our Tax specialists or your usual EPBI contact.