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Tax treatment of termination payments – all change from 6 April

HMRC is introducing new rules for the taxation of termination payments. The changes will come into force on 6 April 2018 and will apply to terminations taking place on or after that date.

Despite the changes being introduced as a means of simplifying the previous regime, the new rules are complex and guidance from HMRC is expected shortly. The key changes are summarised below.

Payments in lieu of notice (PILONs)

All PILONs, irrespective of whether there is a PILON clause in the employment contract, will be treated as earnings and will be subject to deductions for income tax and employer and employee national insurance contributions (NICs). The current distinction between the treatment of contractual PILONS (which were treated as fully taxable), and non-contractual PILONs (which were capable of benefitting from the £30,000 tax exemption and were free of employer NICs), will no longer exist.

Termination awards and post-employment notice pay

A termination award is defined as a payment or other benefit received directly or indirectly in connection with the termination of employment. It does not include a statutory redundancy payment. Although contractual redundancy payments are not expressly excluded from the definition, HMRC has confirmed that they will also not be treated as part of the termination award.

Where an employee receives a termination award, the employer will need to calculate how much of the payment is “post-employment notice pay” (PENP).   

The method for calculating PENP is set out in detail in the legislation; however in broad terms it is calculated as the basic pay that the employee would have received for any unworked period of notice, less any contractual PILON.

If the PENP is equal to or greater than the entire termination award, then the entire award will be treated as earnings and will be fully taxable. If the PENP is less than the termination award, the PENP will be treated as earnings and the remainder of the termination award will be subject to the £30,000 tax exemption (or taxed as earnings if greater than £30,000).

Injury to feelings

From April 2018, payments relating to injury to feelings will be subject to tax, unless they relate to a psychiatric injury or other recognised medical condition. Where an injury to feelings award is made as part of a discrimination claim not related to termination, the payment will still be able to be made tax-free.

Next steps

Employers will need to ensure that they and their payroll providers are familiar with the new legislation by 6 April, and that any settlement agreements they are entering into where the employee’s termination date falls on or after that date take into account the new rules.

Employers will also want to consider whether they should include payment in lieu of notice clauses in all of their contracts of employment going forward, as the main benefit of not including a PILON will no longer exist.

Future changes

The Government has also confirmed that termination payments in excess of £30,000 will be subject to employer NICs, in addition to the current charge to income tax. This change will not be introduced until April 2019, however.

For further information on how this issue will affect your organisation, please contact Victoria Watson, Bridget Prosser or Ron Simms.

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