Taxing termination payments – six months on
Six months on from the introduction of a new regime for taxing termination payments (PENP for those familiar with it), there are still two commonly held, wrong beliefs:
- Nothing has changed and all termination payments are tax free up to £30,000; or
- The change in legislation simply means that all Payments in Lieu of Notice (PILONs) are now taxable.
Neither is true. Although the original idea may have been as simple as taxing all PILONs, it was, in April this year, turned into complex legislation with numerous traps and pitfalls for the unwary. There are areas and definitions which even HMRC have not completely clarified, but employers must navigate the regime carefully to ensure they are deducting tax and where applicable NICs from the correct amount of any termination payment.
Many employers (even sometimes lawyers and accountants) are still not familiar with the new regime. Even if you have got to grips with it, you may find yourself battling to convince your senior management team that anything has changed. They may need reminding that, regardless of any tax indemnity provisions in a Settlement Agreement, HMRC will turn in the first instance to the employer to see whether they have taxed the employee correctly, and that recovering any additional tax due from an employee who has long left is not easy. It is also important that the employer has taken into account the tax that will need to be paid before a settlement figure is agreed/put to the employee, so that the employer does not find it is actually offering less to the employee than was agreed, or alternatively is being asked to make up the difference.
What are the important points and what are some of the practical issues that we are wiser about six months on? The simple way to look at the legislation is to consider that it is trying to capture any unworked period of notice regardless of:
- who gave notice;
- whether a PILON is included;
- whether a PILON is contractual or not.
With that in mind, here are the important starting points:
- The PENP ("Post Employment Notice Pay") calculation must be carried out for all proposed termination payments to employees, even if the payment contains a contractual PILON which the employer intends to tax.
- The only time the PENP calculation would not be necessary is where the employee works, in full, the notice period the employer must give (contractual or statutory, whichever is greater – and regardless of whether it was the employee or employer who gave notice).
- If an employee resigns and works a notice period which is shorter than the notice the employer would have been required to give, the PENP calculation must still be carried out if a termination payment is made.
- Any termination payment proposed to be paid to an employee should first be broken down into its constituent parts otherwise the PENP calculation will be impossible (this does not need to be shown to the employee but it is worth keeping records in case HMRC query the calculation; and in some cases the employee's adviser may ask for details of it);
- It is still relevant whether or not there is a contractual PILON clause because, despite the simple idea, the result of the calculation could be different. It is also relevant to determine whether any contractual PILON clause entitles the employee to all pay and benefits, or, more commonly, to basic salary only;
- While the basic calculation is straightforward enough, employers need to make sure they understand the terms and definitions involved to carry out the calculation correctly. We set out the calculation and many of the definitions in our article from April this year.
Below we answer a few frequently asked questions:
Q: What information do I need to know to calculate the tax due on a termination payment?
A: You need to gather:
- The employee's gross "basic pay" (see our previous article for what is included) before any salary sacrifice is deducted;
- The employer's minimum notice period (statutory or contractual, whichever is longer);
- The date notice was given by either employer or employee, if any;
- The date employment will end or has ended;
- The employee's "pay period" (i.e. what period their regular pay covers – monthly, weekly etc) and the last pay period to end before the "trigger date" (The "trigger date" is the date notice was given, or the employee's last day of employment if no notice was given);
- Whether there is a contractual PILON clause, and if so, what it says;
- What the total termination payment is, and is made up of; and
- Whether any Statutory Redundancy Payment is due/included in the total termination payment.
With this information, the standard PENP calculation is as follows:
Further details of what these various terms mean (e.g. "basic pay", "pay period", "trigger date" and "post-employment notice period") are set out in our previous article.
There is also a "simplified" calculation that can be used in certain circumstances.
Q: What is the simplified PENP calculation and when can it be used?
A: The simplified calculation can only be used when:
- the last pay period before the "trigger date" (see above) is a month (so only for employees paid monthly);
- the employer's contractual notice period applies (rather than the statutory minimum) and it is expressed in the contract in whole months; and
- the post employment notice period is a whole number of months
In the simplified calculation, the calculation above becomes:
BP x D – T
BP is still basic pay in the last pay period, but D can be expressed in months rather than days.
Q: Basic pay in the PENP calculation excludes "allowances". What about car allowances?
A: The answer to this is still not entirely clear, but HMRC's guidance states that "An allowance does not include any amount which is actually, or in reality reflects an amount that has been consolidated into an employee’s standard pay". So, if the car allowance is a constant, guaranteed rate which simply tops up pay, and is not dependant on any particular mileage or usage or any other conditions, it is safest to include this within the definition of basic pay for the purposes of the PENP calculation. This does not mean it is necessarily taxable as part of a PILON if a PILON clause provides for basic salary only. In addition, where there is a genuine choice between the benefit of an actual car (which would not count towards basic pay) and a car allowance, HMRC seem to acknowledge that a car allowance in these circumstances might be excluded from basic pay.
Q: What do I do once I have the PENP figure?
A: Once you have calculated the PENP figure, you need to compare it to the "Relevant Termination Award" (RTA), which is basically any termination payment being paid to the employee except a) a payment which is already going to be taxed (e.g. a contractual PILON taxed as earnings) and b) a Statutory Redundancy Payment (SRP).
|PENP in relation to RTA||Tax and NICs payable|
|PENP equals or is more than RTA||Whole RTA subject to tax and NICs|
|PENP less than RTA but not zero/negative||PENP amount is subject to tax and NICs, and the remainder of the RTA is tax and NIC free up to £30,000|
|PENP is zero/negative||Whole RTA is tax and NIC free up to £30,000.|
Where the £30,000 tax exemption applies, no NICs are payable even above £30,000, although the Government is due to change this from April 2019.
When you have established how much of the RTA is taxable, you then need to make sure that those payments not included in the RTA are also dealt with, namely:
- SRP is added back into any amount falling within the £30,000 tax free threshold
- Contractual PILON or other already taxable payments are subject to tax and NICs
Example 1 (standard PENP formula):
Mrs Jones is entitled to 12 weeks' statutory notice, although her contract says 1 month. Her contract has no PILON clause. She is paid £500 per week. Her termination package will be £20,000. On 1 May she is given notice that her employment will end on 1 June.
BP = £500 (basic pay in the weekly pay period)
D = 84 days (12 weeks' statutory notice) less 31 days' notice given = 53 days
P = 7 days in the pay period
T = 31 days' worked notice subject to tax and NICs = £2,214.29
Using the standard PENP calculation:
RTA is £20,000. PENP is less than RTA. Taxable payment is PENP (£1,571.42) plus the worked notice period which will be taxed as earnings in the usual way (£2,214.29) = £3,785.71 in total. The tax free payment is the balance from £20,000 = £16,214.29.
Example 2 (simplified PENP formula):
Mr Smith is paid £84,000 per year and must be given 6 months' notice by his employer. There is a contractual PILON clause. His pay period is monthly, and the payroll department tells you that in his last pay period he was paid £7,000 gross. He is made redundant with no notice on 31 May. His termination package is £65,000 which includes a statutory redundancy payment of £1,524.
BP = £7,000 in the last pay period
D = 6 months (termination date until earliest date his employment could have been terminated by the employer)
T = £42,000 (contractual PILON taxed as earnings)
(£7,000 x 6) - £42,000 = £0 PENP
The RTA is determined by taking the total termination package of £65,000, subtracting the £42,000 contractual PILON, and subtracting the £1,524 SRP. The RTA is therefore £21,476. PENP is zero, therefore the whole RTA is tax free as it is under £30,000. The SRP is also tax free because when it is added back in, the tax free payment remains under £30,000. The contractual PILON is taxed as earnings.