Ask About … Retail, Fashion & Hospitality

I am an HR Director in a large retail chain and we are planning to make a settlement agreement offer to one of our senior managers. Our Operations Director has been unhappy with his performance for some time and claims that he is well aware of his shortcomings but as far as I know there haven’t been any formal discussions about the issues and nothing has been documented about improvements which are required. The Ops Director wants to remove him quickly, which is why we are planning to make the settlement agreement offer.

This individual is on an annual salary of £80,000 and has a three notice period. He has only been with us for 18 months so doesn’t have unfair dismissal rights. We don’t think he’s likely to have any valid claim for discrimination so we are not planning to offer a high sum in compensation. We thought we would offer an immediate exit with a payment in lieu of notice (PILON) of £25,000 to include salary and benefits, plus an ex gratia payment of £6,666.66. 

We don’t want to get into any negotiations with him and want to make the offer as attractive as possible financially. I understand that up to £30,000 can be paid free of tax and National Insurance (NI) contributions as compensation for termination of employment. Therefore we plan to round up the total of the two payments into a lump sum “compensation” payment of £32,000 and pay the first £30,000 free of tax and all NI deductions. I’ve checked and there is no PILON clause in the contract and we don’t usually make PILONs. Is it okay to pay the first £30,000 free of deductions?

A: Yes that’s fine. Go for it! 

B: The £30,000 “exemption” does not apply to all payments which are made in connection with the termination of someone’s employment. However, as you are rounding up the two figures and calling them a compensation payment it should be fine to apply it.

C: The law on deduction from termination payments has changed recently and both tax and employer and employee NI must be deducted from all termination payments now, including ex gratia sums.

D: As long as the payment is made before 6 April 2018, it should be possible to pay the first £30,000 free of tax and NI deductions. However, the law is going to change for payments made after that date and all PILONs for basic pay (whether contractual or not) must be paid subject to deductions for both tax and NI.

The correct answer is D.

The following changes to the tax treatment of termination payments will apply to payments made on or after 6 April 2018:

• The employer NI rules will be aligned with the income tax rules, so a termination payment which benefits from the £30,000 tax exemption will be subject to income tax and employer Class 1A NI on any amounts over £30,000.  The existing employee NI exemption will be retained, even if the payment exceeds £30,000.
• The distinction between the different types of PILONs will be removed. In broad terms, the basic pay that the employee would have received had they worked out their notice will be  subject to tax and NI in full irrespective of whether there is a clause in the employment contract giving the employer the right to terminate the employee’s employment by making a PILON.  Basic pay for these purposes is the employee’s pre-salary sacrifice pay in the pay period immediately prior to the date on which notice is given or, if no notice is given, the date the employment terminates.  Basic pay excludes overtime, bonus, commission, allowances, share and share option gains and benefits in kind. 
• The “disability exemption” will expressly not apply to compensation for injured feelings, unless the injured feelings amount to a psychiatric injury.  The disability exemption provides a 100% tax exemption for termination payments made only on account of the employee’s disability or injury where the disability or injury prevents the employee from carrying out the duties of their employment.

In addition, those employees (other than seafarers) whose employment terminates on or after 6 April 2018 and who receive a termination payment on or after 13 September 2017 will not be able to claim “foreign service exemption or relief” if they are tax resident in the UK in the tax year in which their employment terminates. Under current law, some or all of a termination payment paid to an employee with a period of foreign service during their employment may be exempt from income tax depending on the length of their foreign service compared to their total service. The new rules could affect a number of individuals, given that it is common for employees whose employment terminates whilst they are on an international secondment to return immediately to the UK.

Residence status for these purposes will be determined in accordance with the normal statutory residence test. Under the statutory residence test both the number of days the individual is present in the UK and the number of ties the individual has with the UK are considered.  

Although the rules around PILONs will be simplified, overall these changes will have significant practical and cost implications for employers and employees. Employers will need to factor in the additional costs in their settlement negotiations. 

In short, employers will face additional expense if they are: 

• making a termination payment in excess of £30,000; and/or
• paying non-contractual PILONs; and/or 
• making a termination payment to internationally mobile employees with foreign service.

Similarly, many employees will find that they have less compensation in their pocket on termination.  The lower paid are likely to be affected by the taxation of non-contractual PILONs, whilst higher paid employees may find their employers reducing the amount that they are willing to pay over £30,000.

Employers with employees on employment contracts which do not contain a PILON clause will also need to have a process in place for calculating the amount that should be subject to income tax and NI.  As mentioned above, the income tax and NI liability arises on the amount of basic pay the employee would have earned had he worked his noticed period calculated by reference to the employee’s pre-salary sacrifice pay in the pay period immediately prior to the date on which notice is given or, if no notice is given, the date the employment terminates. Calculating basic pay by reference to pre-sacrifice salary will also have the effect of increasing costs for employers and decreasing the compensation available to employees.  It seems particularly unfair where the salary sacrifice arrangement has been in place for a substantial period prior to the employee’s employment terminating.