Since 6 April 2018 employers have been required to pay income tax and class one national insurance contributions (NICs) on an element of all termination payments, whether or not they are contractual payments.
What were the previous tax rules on payments in lieu of notice?
Prior to 6 April 2018, if you had a contractual right to make a payment in lieu of notice (PILON), that payment is subject to income tax and national insurance contributions (NICs).
If you don’t have a contractual right to make a PILON (because there is neither an express term in the employment contract nor an established custom and practice of making a PILON), any payment made in respect of an employee’s notice entitlement is generally regarded as ‘damages for breach of contract’ and the first £30,000 can be paid tax-free and without deduction of NICs.
What tax rules will apply to payments in lieu of notice from April 2018?
The element that is now chargeable to income tax and NICs is the amount of the termination payment that represents payment in lieu of notice (PILON).
This change applies to payments, or benefits received on, or after, 6 April 2018 in circumstances where the employment also ended on, or after, 6 April 2018.
This measure is intended to bring fairness and clarity to the taxation of termination payments by making it clear that all PILONs, rather than just contractual PILONs, are taxable earnings.
All employees will pay income tax and class one NICs on the amount of basic pay that they would have received if they had worked their notice in full, even if they are not paid a contractual PILON.
This means the tax and NICs consequences are the same for everyone and are no longer dependent on how the employment contract is drafted or whether payments are structured in some other form, such as damages.
The principle is relatively straightforward but there is a complex statutory formula for calculating the sum that should be taxed, known as ‘post-employment notice pay’ (PENP). PENP is, broadly, the salary the employee would have received during any unworked period of notice minus any contractual PILON. It is calculated by reference to:
- Basic pay only (before any salary sacrifice), disregarding bonus, overtime, commission, benefits in kind etc.; and
- How much statutory or contractual notice (whichever is longer) the employer is required to give to terminate the contract.
PENP is subject to income tax and NICs in full. The balance of the termination payment is eligible for the £30,000 tax exemption and full NICs exemption (provided it is an ex gratia payment).
Statutory redundancy payments are exempt from PENP calculations and qualify for the £30,000 tax exemption, provided they are genuinely paid on account of redundancy.
There may be significant tax implications for non-contractual PILONs made from April 2018. For example:
- An employee’s employment is terminated without notice on 30 April 2018. The employee is paid £5,000 monthly (basic pay); has a three month notice period; and there is no contractual PILON. They receive £35,000 compensation on termination. This an ex gratia damages payment, not linked to any contractual terms such as bonus entitlement.
- Under the current rules, the whole compensation payment qualifies for the £30,000 exemption. Income tax is due on the balance of £5,000.
- Under the new rules, income tax and NICs (both employer and employee) are due on the PENP of £15,000. The balance of £20,000 qualifies for the £30,000 exemption.
All employers should be aware of the new rules and think about how they might impact on termination negotiations. It seems that PENP will need to be calculated for each employee whose employment is terminating including those with contractual PILON clauses (although we are still waiting for guidance from HMRC).
Where there is currently no contractual PILON clause:
- Making a PILON where the termination date is 6 April or later will potentially result in significantly increased costs for both employer and employee.
- Consider whether to exit any employees prior to April 2018 to take advantage of the more favourable tax position.
- Think about including PILONs in contracts going forward. Having a PILON clause allows a payment in lieu of notice to be made without being in breach of contract, thereby preserving any post-termination restrictions. There will no longer be any tax benefit in not including one.