The consultation on the draft legislation designed to simplify the tax and National Insurance treatment of termination payments has recently ended. Paul Tew, Small Business Consultant and Freelance Advisor, looks at how employer’s costs in bringing about employment to an end will be impacted by the proposed changes, which are expected to come into force from April 2018. While this is still sometime away, prudent employers should plan ahead for the introduction of the new legislation.
Amid all the planned changes, the Government is set to retain the following two basic principles:
The first £30,000 of a termination payment remains exempt from income tax.
Any payment paid to any employee that relates solely to the termination of the employment will continue to have an unlimited employee National Insurance contributions (NICs) exemption.
The monetary threshold was last revised at the start of tax year 1988/89. HMRC has confirmed that the tax-free threshold will remain set at £30,000 and not be adjusted to take account of increases in the Retail Prices Index (which if it was, would set the threshold in excess of £70,000).
Payments in lieu of notice (PILONs)
Currently, PILONs that are included in the employment contract are treated as earnings and subject to income tax and NICs, but non-contractual PILONs are not. Therefore, if an employment contract contains a right to receive a PILON then the payment is of earnings. If the contract merely states that a period of notice is to be given by either party in order to end the employment and a contractual right to a PILON cannot otherwise be inferred, then the payment may be tax exempt up to £30,000 and free of any NIC liability on the whole amount. It is this distinction between the two types of PILON, which currently causes confusion among employers that the Government is intending to remove.
From 6 April 2018, all PILONs will be subject to tax and NICs as earnings and all other post-employment payments which would have been treated as general earnings if the employee had worked their notice period will be subject to tax and Class 1 NIC through the payroll. This simplifies the position, but has the potential to increase tax revenues for the Exchequer, so simplification comes with an additional employer cost.
The employee is to be treated as having worked through his or her notice regardless of what actually happens. The average value of employee earnings during this notice period will take into account any salary, benefits-in-kind or bonus that the employee would or should have received. The period to be used is 12 weeks until the end of the employment because the law is intended to cover employees who have fluctuating levels of income.
When these changes come into force, the general distinction between contractual payments made on termination of employment (such as accrued holiday pay) and other non-contractual payments is to be retained.
National Insurance contributions
Under the current rules, income tax is due on termination payments above £30,000 but there is no NICs charge. The £30,000 threshold has no relevance to NICs. The payment is either a payment of earnings and subject to NIC, or it is not earnings, in which case it escapes any NIC liability, regardless of the amount involved.
From 6 April 2018, employer NICs only will be due on all termination payments if they are also subject to income tax. If the total termination payment is less than £30,000, there will be no additional cost to employers, which is probably the majority of payments, but for termination payments above £30,000 there will a further liability for employers to pay.
Example: An employee receives upon termination of the employment £40,000 as compensation for loss of office. The £40,000 will fall under the termination payment rules; the first £30,000 of the payment will be free from both tax and NICs, leaving £10,000 that will be taxed and subject to employer’s NICs. This represents an extra cost of £1380 (£10,000 x 13.8%) to the employer.
Existing total exemptions
There are various exemptions, reliefs and reductions that apply to termination payments in addition to the £30,000 tax threshold. For these exemptions to apply, the payment must be connected to the termination itself and not be contractual. If the conditions of the exemption are met then there is no employee income tax liability, even if payments are in excess of £30,000. The Government plans to retain exemptions relating to payments made under a tax exempt pension scheme, to a registered pension scheme and in respect of certain legal costs, for example, in obtaining independent advice on a settlement agreement.
However, the exemption because of the death, disability or injury of the employee is to be modified to make its application clearer for employers. In order for the exemption to apply, there must be an injury or disability of a physical or psychological nature that is sufficient to cause the employee to be unable to perform his or her job properly. Therefore, the exemption does not apply in cases of injured feelings, such as for harassment or discrimination, unless there is either a psychiatric injury or another recognised medical condition.
In addition, the Government believes that Foreign Service Relief (FSR) should be removed with the provision of relief maintained for seafarers only. FSR allows termination payments for certain qualifying individuals who have worked abroad to be completely exempt from income tax and for those who do not qualify for a 100% deduction, to receive tax relief, which is proportionate to their time worked outside the UK for that employer. The Government considers that this exceptional treatment is no longer justifiable in today’s world of an international labour pool of workers. Employees with previous service abroad will continue to benefit from the £30,000 threshold. The Government does not intend to introduce any new exemptions.
The new legislation
The legislation, as may be amended following this latest consultation, is to be included in Finance Bill 2017. The employee’s termination payment is effectively to be divided into two types of payment: payments that can still benefit from the £30,000 threshold and those that cannot. The legislation specifically treats payments such as statutory redundancy or an unfair dismissal award as being subject to the £30,000 threshold. There is to be an anti-avoidance rule to prevent artificial reductions in general earnings in anticipation of a termination.
Employers will have to first identify any payments that should be treated as earnings and any remainder is then subject to the £30,000 threshold. In order to determine which post-employment payments (or proportion of a payment) will be subject to the exemption, employers will need to refer (as is the case now) to the employee’s underlying employment contract and other terms and conditions. Any payment covering part of the existing contractual entitlement, including the notice period, even if the employee does not work it, will be earnings. Anything that is non-contractual will be the termination payment which will be taxed and subject to employer NICs on any amount that exceeds the £30,000 threshold.
Interestingly, there is a specific power to vary the £30,000 exemption threshold at some future point.
Last reviewed 8 November 2016