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Changes in the taxation of termination payments

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6 October 2017

The taxation of termination payments has notoriously been a grey area and, as a result, has been an area targeted by HMRC, with numerous tax cases in recent years.

From April 2018, changes to the rules for the taxation of termination payments are due to come in. This includes a provision such that all payments in lieu of notice (PILONs) will be fully taxable and subject to National Insurance Contributions (NIC).  

Termination payments 

Termination payments are payments compensating an individual for the loss of his/her job. They can take the form of cash or benefits in kind. Termination payments will either be fully taxable, partially taxable, or fully exempt depending on the nature and the amount of the payment.

Current rules

Currently, the tax treatment of PILONs (i.e. the basic amount of pay that an employee would have received if they had worked their notice in full) depends, broadly, on whether there is a contractual entitlement to the payment.

If there is a clause in the employment contract for a PILON, it is currently taxable in full and subject to NIC.

If the PILON payment is non-contractual, the first £30,000 will generally be exempt from income tax and neither employer’s or employee’s NIC will be applicable on the whole amount. There are, however, some exceptions to this depending on the specific facts and circumstances of the payment.

Proposed changes

The main changes included in the September 2017 Finance Bill are:  

  • All PILONS, regardless of whether they are contractual or not, will be fully taxable and subject to employer’s and employee’s NIC. Such amounts will be treated as earnings of the individual.
  • For all other non-contractual termination payments, the £30,000 exemption should continue to apply.
  • Employers will be required to pay Class 1 NIC (currently 13.8%) on any termination payments to which the £30,000 exemption applies, but only on the amount above the threshold. This could be a significant additional cost for employers and will need to be factored into the costs of redundancy programmes. Employees will continue to be exempt from Class 1 NIC on the full amount.
  • Foreign service relief, for employees who have spent time working outside of the UK, will be also be removed, with the exception of seafarers.
  • Lastly, the full exemption from tax for payments made on injury or disability of the employee will be amended to clarify that this does not apply to injury of feelings.

If the employee’s termination package consists of a single compensation payment under a compromise agreement, the amount relating to the post-employment notice period (i.e. the PILON) will still be taxable in full.

For example, an employee with a basic salary of £80,000 receives a compensation payment of £30,000 under a compromise agreement, (none of which is subject to tax under other rules). The employee is required to give three months’ notice as per their contract and there is no PILON clause:

£20,000 of the compensation is treated as related to the post-employment notice period (i.e. 3/12 x £80,000) and will be taxable in full and subject to Class 1 NIC. The remaining £10,000 should be subject to the £30,000 exemption.

Responsibility

It is the employer’s responsibility to apply the correct tax treatment to the termination payment. The employer will, therefore, be subject to any unpaid tax, penalties and interest if the payment is not treated correctly.

Application

The legislation for these changes has been included in the September 2017 Finance Bill, following its removal from the 2017 Finance Bill earlier this year. This was a case for a number of clauses due to the general election, with parliament running out of time to debate the proposals.

Until the legislation is enacted, we cannot say with certainty that the changes as set out above will come into force. We don’t, however, expect any material changes to the proposals.