Tax treatment of termination payments – draft legislation published

Some of the suggestions have been extremely complex and, as previously reported, the Chancellor’s confirmation in the Autumn Statement of a simpler approach is welcome. 

That said, in the world of tax, “simplification” is a relative term.  The draft tax and NI legislation, which was published in December for consultation, is still over 8 pages long!

What is changing?

Three key changes are proposed to the tax and NI treatment of termination payments paid on or after 6 April 2018.  These are: 

• The employer NI and income tax treatment will be aligned, so a termination payment which benefits from the £30,000 income tax exemption will be subject not only to income tax on the excess over £30,000 but also employer class 1A NI.  Employers who make termination payments in excess of £30,000 will therefore face an additional cost of up to 13.8% on the excess.  The existing employee NI exemption on termination payments will be retained, even if the payment exceeds £30,000.
• The distinction between the different types of payments in lieu of notice (“PILONs”) will be removed.  The amount of basic pay that the employee would have received had he worked his notice will be treated as earnings and subject to income tax and NIC in full, regardless of whether or not the employee has a contractual entitlement to the PILON.
• Foreign service relief and exemption will be abolished.  Under the current legislation if the employee has a period of foreign service during his or her employment, some or all of the termination payment may be exempt from income tax depending on the length of the employee’s foreign service in that employment compared to his total period of service in that employment.  Foreign relief and exemption will be replaced by an exemption for payments made on the termination of employments performed wholly abroad by an employee who is not resident in the UK. 

A clarificatory measure is also being introduced.  Under the current legislation if, at the time the employment terminates, the employee is suffering from a disability or injury which prevents the employee from carrying out the duties of his employment, the employer can make a tax and NI free termination payment to that employee provided the payment is made solely on account of the disability or injury.  The legislation will be amended to make it clear that injury does not include injured feeling unless it amounts to a psychiatric injury or other recognised medical condition.

What do the changes mean for employers and employees?

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.  This is calculated on a pro rata basis by reference to the employee’s basic pay over the year prior to the termination date (or if the employee has been in that employment for less than a year over that shorter period).

Basic pay excludes overtime, bonus, commission, allowances and benefits.  However, where the employee has entered into a salary sacrifice arrangement, it is calculated by reference to the employee’s pre-salary sacrifice salary.  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.

Consultation on the draft legislation closes on 1 February 2017.  If you have any comments that you would like us to include in our response, please get in touch.