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New Rules on Termination Payments Come into Force

May 8, 2018 Termination Payments

On 6 April, new rules came into force governing the taxation of termination payments made to staff when a contract of employment is cancelled.

Under the new regulations, employers and employees are obliged to pay Income Tax and Class 1 National Insurance Contributions (NICs) on all termination payments, regardless of whether they are made on a contractual or non-contractual basis.

The changes seek to clarify and simplify tax exemptions for PILONs, or payments in lieu of notice – payments made when employment ends before a minimum notice period is served, and therefore in place of a normal wage.

Previously, PILONs were liable for tax depending on whether they were paid automatically based on the terms of the contract. If the payments were non-contractual, employers could avoid paying tax.

This approach came in for criticism because employers were able to structure payments so at least some part appeared non-contractual – a compensatory ad hoc payment made as a gesture of good will, for example – and therefore liable for less tax.

This then led to a convoluted and complex process of HMRC having to analyse how an employer behaved in the majority of cases to decide whether, in fact, such ad hoc, non-contractual payments were in fact customary, in which case they could be deemed taxable.

How the new system works

The new system removes the distinction between contractual and non-contractual PILONs, making at least part of all termination payments liable for Income Tax and NIC. It introduces a new requirement for employers to work out how much the employee would have earned from basic pay if they had completed their notice period – known as the post-employment notice period, or PENP.

However much is actually paid upon termination of the contract, the amount that equates to the PENP amount is treated as earnings for Income Tax and NIC purposes. Any further sum that is paid out in addition is exempt from NIC and exempt from tax up to a £30,000 limit.

The PENP category therefore brings PILONs into line with what happens when an employee does complete their notice period at the end of a contract – both they and their employer have to pay tax and NIC on their earnings as usual.

The new regulations also reform other tax exemptions which exist for termination payments. For example, termination payments in circumstances where employment ceases due to disability or injury are fully exempt from tax. This previously included a category for ‘injury to feelings’, but this has now been scrapped.

Further changes to the system will be introduced next year, when Class 1 NIC exemptions for employers will be brought into line with the £30,000 Income Tax threshold, meaning employers will have to pay both tax and NIC on the total amount of termination payments above £30,000.