People walking through city.
Termination payments
Susan Ball
08/06/2018
People walking through city.
Last year the government embarked on a series of reforms to the tax and National Insurance Contributions (NIC) treatment of termination payments made by companies to their employees.

Most of the changes came into effect in April 2018, but further updates are planned for April 2019. There are major changes to the income tax and NIC treatment of termination payments to employees, where the legislation has not seen any significant change for around 30 years.

For termination dates after 6 April 2018 the key is use the formula, as set out below, when dealing with any payments which are not being subject to tax and NIC.

What are the changes?

From 6 April 2018 the legislation:

  • effectively treat all payments in lieu of notice as earnings as subject to tax and class 1 NICs
  • ensure that payments for injury to feelings fall outside the exemption for injury payments, except where the injury amounts to a psychiatric injury or any other recognised medical condition
  • abolish foreign service relief (except in relation to seafarers) for UK resident employees.
  • permit HM Treasury to vary the £30,000 threshold by regulations

From 6 April 2019, the legislation will:

  • subject all termination payments above the £30,000 threshold to class 1A NICs (employer liability only)

Below we cover the two major changes which will impact many employers.

What is the change to payments in lieu of earnings?

Over the years, for payments in lieu of notice (PILON), the tax/NIC treatment has often been inconsistent. Though where there is no mention in the contract or any discretion, the PILON has generally been treated as a 'damages payment' for breach of contract, and as such can qualify for the £30,000 tax exemption (and full exemption from NIC). These new rules will change this current way of working.

The legislation works by first identifying any payments that should be treated as earnings and any remainder is then subject to the £30,000 exemption.

Broadly, the intention is to tax, as earnings, the basic pay the employee would have earned had the employee worked his or her notice. It is worth bearing in mind also that anti-avoidance provisions have been included in the legislation.

As an employer, how can this be calculated?

Although slightly complicated, the way to work this out is using the formula ‘(BP x D/P) minus T’, where:

  • BP = work out basic pay for the last pay period to end before the trigger date (the day notice is given or if notice is not given, the last day of employment)
  • D = Length of the Post-employment notice period in days
  • P = number of days in the pay period used to calculate Basic Pay
  • T = is amounts (other than holiday pay and termination bonuses) that are paid on termination but are taxable as earnings.

Things are slightly simpler if the employee gets paid monthly, as the notice period and the “post-employment notice period” are both expressed in months.

The post-employment notice period begins at the end of the last day of employment and ends with the earliest lawful termination date. There are some additional provisions covering fixed-term contracts with no contractual notice provision.

How is basic pay defined?

Basic pay is employment income, disregarding overtime, bonuses, commissions, gratuities, allowances, termination awards, benefits in kind and amounts treated as earnings (such as share-based earnings). However, basic pay does include sums that would have been received, absent a salary sacrifice arrangement.

Example 1

George is paid £6,000 monthly (basic pay) and has a three month notice period. George employment is terminated without notice. The employer makes a termination payment of £30,000. George's contract does not include a contractual PILON. There is a month in the last pay period. Applying the formula:

  • BP – Basic Pay – £6,000
  • D – Length of the Post-employment notice period – 3 months
  • P – Number of days in the pay period used to calculate Basic Pay – 1 month
  • (BP x D/P) = £6,000 x 3 /1

Therefore the post-employment notice pay of £18,000 is subject to tax/NIC.

The employer will then need to consider whether to treat the other amount under the normal termination payment tax rules.

Example 2

Mary's contractual pay is £7,000 plus a salary sacrifice of £1,000 therefore £8,000 is monthly (basic pay) and she has a three month notice period. Mary's employment is terminated due to redundancy with one months' notice.

The employer makes a termination payment of £50,000. There is a payment of £100 for a restrictive convenant. Redundancy pay of £10,000 is included. Mary's contract does not include a contractual PILON. There is a month in the last pay period. Applying the formula:

  • BP – Basic Pay – £8,000
  • D – Length of the Post-employment notice period – 2 months
  • P –  number of days in the pay period used to calculate Basic Pay – 1 month
  • (BP x D/P) = £8,000 x 2 /1

Therefore the post-employment notice pay of £16,000 is subject to tax/NIC.

The employer will then need to consider whether to treat the other amount under the normal termination payment tax rules.

The £100 for a restrictive covenant will be subject to tax and NIC. In this case of the remaining £33,900 - £30,000 will be tax free and NIC free and £3,900 subject to tax.

What about the £30,000 exemption?

This limit has not changed, however there has also been an anomaly between the tax and NIC rules, in that termination payments which are not 'earnings' are exempt from NIC both for employers and employees without limit.

Originally the government sought to change this at the same time as the other legislation, but this has now been postponed until April 2019, where a £30,000 cap will be introduced for NIC, but for employer's NIC only, by way of Class 1A.

What are the implications?

As these changes are far-reaching employers and employees will need to adjust their thinking to make sure they get the right treatment. This will take time, given the existing rules have not been changed for many years.

For those dealing with terminations in the run up to April 2019, when there will be a new employers’ NIC charge.

Unfortunately, although the process of updating the legislation aimed to clarify existing rules, the new changes are not immediately straightforward. Where employers are uncertain of their obligations with regards to termination payments, they should seek specialist advice to ensure they remain compliant and keep an eye out for HMRC guidance.

Contact us

Susan Ball
Susan Ball
Partner, Head of Employers Advisory Services
London