In September 2015, we reported on the government's consultation on simplifying the taxation of payments made on termination of employment. The consultation response has now been published along with draft legislation, which is expected to take effect from April 2018.
The current tax and national insurance treatment of payments made on termination of employment has been criticised for being unnecessarily complicated and open to manipulation by employers. The draft legislation aims to make the system easier and fairer for all.
We set out the key changes that are being made and how they will affect employers and employees. Please see the consultation response for further details.
Currently, contractual payments made in lieu of notice (PILONs) are taxed as earnings whereas genuine non-contractual PILONs, which are not paid by the employer as an automatic response to termination, are not. The present system often requires scrutiny of employer custom and the PILON-payment decision in order to determine the tax implications.
Under the new legislation, this contractual/non-contractual distinction will be removed. All PILONs will be taxed as earnings and will be subject to income tax, employer national insurance contributions (NICs) and employee NICs.
As well as notice payments, any other post-employment payments (such as expected bonus income) that would have been treated as earnings if the employee had received them during the notice period will be taxed. This will apply even if the employee does not work out any or all of the notice period.
The consultation sought opinion on whether to introduce a variable threshold for the payment of income tax and NICs. The suggestion was that this could be linked to the employee's length of service, coupled with the introduction of various new exemptions. These proposals have been put to one side in favour of maintaining a clear threshold figure.
Termination payments of up to £30,000 will remain exempt from income tax, employer NICs and employee NICs. The exemption will apply to any balance remaining after notice payments and other taxable payments have been taken into account and taxed accordingly. For genuine termination payments, this maintains the current position and is motivated by the government's wish to support those who lose their job.
What of those compensation payments that exceed £30,000? Currently, the proportion of a termination payment above £30,000 is subject to income tax only and is free of employer and employee NICs.
The consultation response explains that the rules on income tax and employer NICs are to be aligned. From April 2018, the excess above £30,000 will also be subject to employer NICs. However, the whole termination payment will remain outside the scope of employee NICs.
Under the current system, there are various exemptions, reliefs and reductions that apply to termination payments in addition to the £30,000 threshold. Qualifying payments have no income tax liability even if it they are over £30,000.
One such exemption is for payments made because of the death, disability or injury of the employee. Divergence of judicial opinion on whether payments for injury to feelings fall within this exemption has left the current position in a state of uncertainty.
HMRC has clarified its own understanding of the current legislation: "the exemption does not apply in cases of injured feelings. 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." As a result, the government plans to amend the legislation to make clear that the exemption does not apply to payments for injury to feelings.
Currently, Foreign Service Relief allows termination payments for qualifying individuals to be completely exempt from income tax. It applies to employees who receive termination payments whilst working in the UK but have also worked for their employer outside of the UK for more than 75% of the last 20 years. A smaller proportionate relief may apply to individuals who do not meet the criteria for a full deduction.
From April 2018, this relief will be abolished. The government believes it to be outdated and unnecessary given the global workforce we have today. However, those who have worked abroad will continue to benefit from the £30,000 tax-free threshold.
For many the changes will be a welcome simplification to a system that is prone to causing confusion at best and unwelcome tax liabilities at worst. That the consultation response drops some of the more complicated proposals will also be positively received.
However, employers should be aware that the changes are likely to make termination more costly. The reasons for this are twofold. Firstly, the changes to the treatment of PILONs and compensation payments above £30,000 will increase liability to employer NICs. Secondly, increased financial packages may have to be offered to exiting employees to counter the lower net figure the employee is likely to receive under the new regime.
As the employee's liabilities to income tax and employee NICs will also expand following the changes, employers will wish to take extra care that a robust tax indemnity is put in place on termination.
Over the coming months we can expect the inevitable ironing out of the draft legislation's wording. However, the end result and impact should remain much as set out above; one to keep on your radar ahead of April 2018.
For more information and advice on how these changes will affect your business please contact your regular employment contact or Lizzie Stone, Employee Tax Specialist.
Contributors: Hayley Butler and Amy Whiting
This publication is intended for general guidance and represents our understanding of the relevant law and practice as at August 2016. Specific advice should be sought for specific cases. For more information see our terms & conditions.