Taxation of Termination Payments.
From April this year, all payments in lieu of notice (PILON) are now subject to tax. This change is designed, in the words of the government, to “simplify and tighten” the rules around the taxation of termination payments and represents is a significant change from the previous position where different arrangements applied depending on whether there was a PILON clause in the employee’s contract.
Taxation of PILON The Previous Regime
Under the previous regime where there was a clause within an employee’s contract allowing for the payment of PILON, the PILON payment was taxed as earnings. This was because it was a payment derived from the employment contract.
On the other hand, where there was no PILON clause in the contract and the employer forced a employee to take pay in lieu of notice, then the PILON payment was generally regarded by HMRC as damages for breach of contract (the breach being the employee’s contractual right to work his notice period) rather than as a true PILON payment. Damages are given a different taxation treatment by HMRC and are tax free up to a limit of £30,000 in any single tax year. This meant that the PILON payment in such cases could usually be made to the employee without the deduction of any tax up to the limit of £30,000.
However, there were exceptions to this which could cause confusion and uncertainty. For example, if there was a custom and precedent on the part of the employer to deduct tax from PILON payments even when there was no PILON clause in the contract, then HMRC could take the position that an implied contractual right to PILON had arisen and that the payment was taxable regardless. This could cause difficulties in settlement negotiations where the employer would want to deduct tax when there was no PILON clause whilst the employee would insist that the payment should be made gross.
In such cases the employer would usually insist on an indemnity from the employee in a settlement agreement. But indemnities are unsatisfactory in many ways – the employer would have to enforce it, if necessary through the courts, and even then there was no guarantee that the employee would have the resources to pay.
The New Regime
The new position is that all PILON payments will now be subject to income tax and employee Class 1 NICs regardless of whether or not there is an express PILON clause in the contract.
This change essentially splits termination payments into two elements.
The first element is known as “post-employment notice pay” (PENP). This represents the amount of basic pay the employee will not receive because their employment was terminated without full or proper notice being given. This element will be subject to income tax and employee Class 1 NICs.
The legislation sets out a complex statutory formula to calculate the PENP, which involves carrying out calculations to establish the employee’s basic pay, the amount of the notice period outstanding following the termination date and the number of days in the employee’s last pay period. Once PENP has been calculated, any contractual PILON payment can be deducted to give the final taxable sum.
There is not yet any HMRC guidance on how to perform the PENP calculation. At present appears the PENP only takes into account basic pay, and that bonus and commission payments are not included. HMRC has promised that further details of how and when the PENP calculation should be applied will become available in due course.
The second element is the remaining balance of the termination payment. The balance of the payment is tax free up to £30,000 (provided that it is an ex gratia payment). Any excess over £30,000 will be subject to income tax. Employees will continue to benefit from an unlimited NIC exemption for payments related to the termination of employment, so the whole of the balance of the payment will be free from Class 1 NICs.
The new rules will not apply to statutory redundancy payments, which can still be made tax-free in their entirety.
• An employee’s employment is terminated without notice. The employee is paid £5,000 per month basic pay, they have a 3 month notice period and there is no PILON clause in the contract. The employee receives £35,000 compensation on termination.
• Under the old regime, £30,000 of the payment would have qualified for the whole tax free exemption. Income tax would have been due on the balance of £5,000 compensation which went over the £30,000 tax free limit.
• Under the new regime, 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.
The Way Forward
Employers with no PILON clauses in their standard contracts may now want to consider including them, as there is no potential tax advantage in not including the clause. Employers may also wish to consider including a contractual PILON clause, as they will still be in breach of contract if they pay a PILON payment where there is no clause in the contract. Being in breach of the employee’s contract makes it difficult to enforce other terms of the contract, such as restrictive covenants.
Employers still have the option of insisting an employee work their notice, or placing them on garden leave for their notice period.
For further information please contact a member of the Employment team.