Tax treatment of termination payments - the sting in the tail

In 2015, the Government launched a consultation to simplify the tax and national insurance (“NI”) treatment of termination payments. As previously reported, following that consultation the Government announced that it proposed to amend the rules with effect from 6 April 2018.

Overview of the proposals

A further consultation has now been published confirming the proposed changes together with draft legislation. In broad terms, the Government is proposing to:

1. Align the employer NI and income tax treatment, 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 NI. This will increase the cost to an employer of making a termination payment of more than £30,000 by up to 13.8%. The existing employee NI exemption on termination payments will be retained, even if the payment exceeds £30,000.
2. Remove the distinction between the different types of payments in lieu of notice (“PILONs”). All PILONs will be treated as earnings and subject to income tax and NI in full, regardless of whether or not they are contractual.
3. Ensure that any other payments or benefits that the employee would have received if his employment had not terminated will be subject to income tax and NI in full.
4. Remove foreign-service exemption and relief, which is currently available to those employees who have spent some years working abroad for their employer.
5. Ensure that compensation for injured feelings on termination does not benefit from the 100% tax and NI exemption that is available for payments in respect of injury and disability, unless those injured feelings amount to a psychiatric injury or other recognised medical condition. This is a welcome clarification as there have been conflicting approaches from the employment tribunals on the one hand and the tax tribunals on the other. This does not affect injury to feelings for pre-termination discrimination, which will continue to be tax-free up to certain limits.

PILONs, benefits and bonuses in more detail

The aim behind the proposals set out in 2 and 3 above is to ensure that only those payments which are “directly related” to the termination of the employment benefit from the £30,000 tax and employer NI exemption. The draft legislation provides that any part of the termination payment which in broad terms is not an award of compensation for unfair dismissal or a redundancy payment is potentially subject to income tax and NI in full, depending on the total amount of the employee’s “post-employment notice income” and “expected bonus income”.

“Post-employment notice income” is the amount of earnings (excluding bonus income) that the employee would have received had they worked their notice period, calculated by reference to the employee’s earnings for the 12 weeks prior to the termination of employment. Currently, if there is no PILON clause or the PILON only requires the employer to pay basic salary, a sum paid to compensate the employee for loss of taxable benefits is eligible for the tax and NI exemptions. This change means that any sum to compensate the employee for the loss of taxable benefits in kind that the employee would have received if he had worked out his notice will be subject to income tax and NI in full. This will be so even if the PILON clause only requires the employer to pay basic salary (as is often the case), or there is no PILON clause in the contract at all.

“Expected bonus income” includes “commission, incentives or anything similar”. This will also be subject to income tax and NI in full. Under the draft legislation, bonus income is “expected” if:

• The employee could have reasonably been expected to receive it during their notice period had they worked out their notice period; and/or
• The employee could have reasonably been expected to receive it if they had continued in employment long enough to do so, in respect of times either before the end of the employment or before the end of the notice period if they had worked out their notice period.

An example

By way of example, assume an employee on £100,000 with a three-month notice period is dismissed without notice on 30 June. The employee’s contract does not contain a PILON clause. The value of the salary and benefits that the employee would have received during his notice period is £28,000 (£25,000 PILON and £3,000 worth of taxable benefits in kind). In addition, the employee would have received a bonus of £25,000 for performance during his employment if he had carried on working until the end of the year. The employer and employee reach a settlement of £75,000.

It seems that the tax and NI treatment of the settlement payment would be as follows.

• Any part of the settlement payment which was for redundancy or an award of compensation for unfair dismissal would be eligible for the £30,000 tax and employer NI exemption and the employee NI exemption.
• If no part of the settlement payment was for redundancy or an award of compensation for unfair dismissal, it would be taxable as follows:
• £25,000 PILON would be taxable and subject to NI in full.
• £3,000 cash equivalent of benefits in kind would be part of the employee’s “post-employment notice income” and so taxable and subject to NI in full.
• £25,000 “expected bonus” would be taxable and subject to NI in full.

This would mean that only £17,000 of the settlement payment would be eligible for the £30,000 tax and employer NI exemption and the employee NI exemption. This is potentially a significant reduction in the tax-free amount as compared to the current position, where the full £30,000 would be eligible for the exemptions.

Any “award” of compensation for unfair dismissal can be paid tax-free up to £30,000, but it is unclear what this means. Is this something that the employer can specify in a settlement agreement, or does it require an award to have been made by a tribunal? Hopefully this is something that can be clarified following the consultation process.

The sting in the tail

While it is good news that many of the more draconian suggestions in the 2015 consultation have been abandoned - including replacing the £30,000 exemption with a much less generous exemption linked to length of service – the example above shows there is a sting in the tail. Although some of the proposals will simplify the tax treatment of termination payments, the need to establish post-employment notice income and expected bonus income will increase the complexity – indeed, the draft tax legislation is some seven pages long!

In addition, the changes will make termination payments more expensive for employers and result in many employees having less money in their pocket. This will particularly affect the lower paid, who are more likely to receive a termination payment under £30,000 and often only receive a non-contractual PILON.

We will be responding to the consultation, which closes on 5 October 2016. If you would like to discuss any issues arising out of these proposals or have any comments that you would like us to include in our response, please get in touch.

A number of other consultations were issued on the same day as the termination payments consultation, most notably a consultation proposing to limit the benefits in kind which attract a favourable tax and NI treatment when provided via a salary sacrifice arrangement. Some key benefits will not be affected, such as contributions to pensions, cycle-to-work schemes and employer-supported childcare. If you have any concerns or comments about the salary sacrifice consultation, please also feel free to let us know.