Several changes have taken effect from April 2018 altering the taxation of payments in connection with the termination of employment. These changes were introduced with a view to simplify, clarify and modernise the tax regime applying to termination payment. Indeed, each of these verbs were used in the various HMRC and government releases. The Office for Tax Simplification must be delighted
In summary, these changes include:
- A Payment in Lieu of Notice (“PILON”) will always be subject to taxation as earnings regardless of whether it is or isn’t contractual.
- The introduction of ‘Post-Employment Notice Pay’ which calculates the basic salary which would be subject to Income Tax if the employee worked their notice period
- The removal of Foreign Service Exemption (“FSE”) relief for those tax resident in the UK when their employment is terminated
- The introduction of Class 1A National Insurance Contributions (“NICs”) on all qualifying termination payments above the £30,000 exemption. This is expected to take effect from April 2019.
The Old Regime
Broadly, the taxation of benefits received in connection with the termination of an employment would depend on whether a payment was determined to be a payment as a reward for services (i.e. earnings) or compensation for loss of office.
Generally, a payment was a reward for services where:
- The payment is contractual. This includes a contractual Payment in Lieu of Notice (“PILON”) which is technically a payment for a breach of contract
- The payment is not contractual but is reasonably expected. For example, if the company habitually or as custom provides a £10,000 termination payment to those whose employment it terminates
- If the employee is put on garden leave – paid to stay at home – the employment ends at the end of garden leave (note the distinction from a PILON)
- A restrictive covenant – a payment in lieu of the employee’s right to do something
Such payments would be subject to Income Tax and National Insurance Contributions (“NIC”) accordingly.
Statutory redundancy pay and any voluntary payments (ex-gratia) by an employer in connection with termination of employment would generally be subject to tax as compensation for loss of office.
Any amounts deemed compensation for loss of office would be subject to a £30,000 exemption and subject to Income Tax as the top slice of income at the marginal rate(s). This amount would not be subject to NICs.
This treatment would also apply to non-contractual PILONs. Although, technically a PILON is a compensatory payment for breaching the right to a notice period as opposed to compensation for loss of office.
The benefits of ‘compensation for loss of office’ extended further to those who worked overseas, allowing for the whole payment to be exempt if:
- 75% of employment service was carried out overseas
- Total employment service exceeded 10 years and the whole of the last 10 years of service was spent outside the UK
- Total employment service exceeded 20 years of which 50% is overseas services making up 10 of the last 20 years
Therefore, payments falling within the ‘compensation for loss of office’ treatment benefitted both employees and employers.
If the full FSE relief did not apply, the termination payment which constituted compensation for loss of office (as opposed to earnings) would be relieved proportionately by any amounts of employment service spent overseas by reference to total employment service.
The Changes from April 2018
Much of the old regime remains unchanged. The changes which took effect 6th April 2018 revisit the position in respect of a Payment In Lieu Of Notice (“PILON”) and the availability of Foreign Service Exemption (“FSE”) relief.
Post-Employment Notice Pay
The new legislation effectively distinguishes between two elements of a termination package:
- Post-Employment Notice Pay (“PENP”) – The basic pay which would have been subject to tax as earnings had the employee worked their (unworked) notice period. This is calculated by reference to a statutory formula.
- Relevant Termination Awards – Any amounts above the PENP which are subject to taxation as compensation for loss of office (i.e. subject to the £30,000 exemption) excluding statutory redundancy pay and ‘approved contractual payments’.
Any PENP, along with any other payments deemed to be a reward for services, will be subject to Income Tax and NIC as earnings. The relevant termination awards will benefit from the £30,000 exemption and Foreign Service Exemption. Although, as you will see below, the availability of Foreign Service Exemption is being restricted and the government plan to introduce Class 1A NICs to such payments.
The PENP is calculated by reference to basic pay which would have been paid had the employee worked any periods of unworked notice period. The formula which applies is:
BP equals the employees basic pay with distinct items to be excluded such as bonuses, commission, amounts subject to the benefits code etc. The basic pay is by reference to the last payment period i.e. weekly wage / monthly salary
P is the number of days in that last payment period
D is the number of days of legal notice period forgone
T equals any amount or benefit received in connected with the termination which is already subject to Income Tax and is not pay in respect of holiday entitlement or a bonus payable for termination of the employment
Foreign Service Exemption
The changes to FSE do not affect how they operate, but rather the circumstances in which such relief is available. If an employee is tax resident in the UK at the time their employment is terminated, FSE will not be available.
This may give rise to several practical considerations. For example, often, a person’s residency status may not be ascertained until the tax year has come to an end, especially when relying on the sufficient ties tests.
However, the relief is retained for ‘seafarers’.
The policy objective for this change is based on the believe the relief for foreign service is outdated and unnecessary. This aligns the tax position for UK resident’s regardless of whether they have worked abroad or not.
Tim, who receives a basic salary of £5,000 per month plus private health insurance and a company car, is made redundant on 5th June 2018. Under the terms of the contract, Tim is entitled to a four weeks notice period. However, legally he is entitled to a six weeks notice. Tim works one week of his notice period and receives a £3,000 PILON in respect of the remainder.
Tim spent one year during his 5-year employment working in Spain but was tax resident in the UK at the time his employment was terminated.
Tim’s termination package is made up of the following:
- Statutory Redundancy payment of £5,000
- A contractual bonus of £10,000
- Compensation for loss of office of £45,000
- A contractual PILON of £3,000
The Old Rules
Under the old regime, the full amount of the PILON (£3,000) & the contractual bonus (£10,000) would be subject to Income Tax and NIC as employment income.
The remaining £50,000 (statutory redundancy & Compensation for loss of office) would be subject to the £30,000 exemption leaving £20,000 before the application of FSE. does not qualify for full FSE relief and is given relief proportionate to the amount of time service which was spent overseas of £4,000 (£20,000 x 1/5).
This left £16,000 to be taxed at the marginal rate as compensation for loss of office.
The New Rules
Under the new regime, the relevant termination award is £45,000.
The PENP is calculated as follows:
BP is the employee’s basic salary in respect of the last full pay period i.e. £5,000
D is the number of calendar days of notice period the employee was entitled to but didn’t receive – 35 days
P is the number of days in the last pay period (I.e. 31 days of May)
The relevant termination award subject to taxation as ‘compensation for loss of office’ consists of statutory redundancy pay and compensation for loss of office less PENP which equals £47,355. After application of the £30,000 exemption, the amount subject to Income Tax at the marginal rates is £17,355. If relevant, FSE will then be deducted.
The remainder is subject to Income Tax as earnings and consists of PENP, contractual bonus and the contractual PILON equalling £15,645.
|Payments in connection with termination||63,000||63,000|
|Taxed as earnings||13,000||15,645|
|Taxed as compensation for loss of office||16,000||17,355|
The Changes from April 2019
The government have announced changes to the NIC position of termination awards subject to taxation as ‘compensation for loss of office’ to take effect from April 2019. Class 1A NICs will be due on termination payments of more than £30,000.
The intention here is to bring the NIC treatment in line with the Income Tax position without burdening the employee. Therefore, the Class 1A charge is extended. Usually, items chargeable to Class 1A NICs are declared and paid via the P11D process. This is due to be reported by 6th July following the relevant tax year end.
However, HMRC have anticipated that the Class 1A charges arising under these termination payments will arise and be collected in real time.
These changes were intended to simplify and modernise the regime of taxation applying to the payments received in connection with termination. My personal view is that the previous regime was simpler.
The taxation of termination payments will still require consideration as to whether a payment was contractual or not. However, further consideration will be needed in respect of the PENP formula and calculating relevant termination awards. A further point yet to be determined is how the Class 1A NICs will be collected from employers.
Whilst, these provisions might simplify the regime in ensuring that all PILONs are taxed as earnings and aligning the position of those tax resident with that non-resident in respect of FSE, it’s clear that this is at the expense of employee and the employer. Indeed, this would be supported by the summary of impact (benefit) to the exchequer with the changes expected to provide a benefit to the exchequer of £400m in 2019 – 2020.
Employers would be advised to review their termination/redundancy policies to ensure they are suitable and tax compliant. Employees should also be notified of these changes, especially those who have spent time working overseas.
This article was in published in our May 2018 enewsletter. To be added to our mailing list, click here and submit your contact details on our sign up form.