UK employers currently contemplating or negotiating employee termination agreements as well as employees anticipating receipt of termination payments should be aware of changes to the relevant tax regime which will apply for the 2018-19 tax year onwards.
These new rules affecting employment termination payments made after 5 April 2018 are included in Finance Act (No.2) 2017. These changes are designed to align the rules for tax and secondary National Insurance contributions (employer (NICs) by making an employer liable to pay NICs on termination payments they make to their employees.
An employer will be required to pay NICs on any part of a termination payment that exceeds the £30,000 threshold.
All other termination payments i.e. damages for breach of contract, redundancy and ex-gratia payments will be included within the scope of the £30,000 termination payments exemption.
The changes are designed to introduce fairness between the treatment of contractual and non-contractual payments in lieu of notice ('PILON') insofar as all will be subject to tax and NIC irrespective how the employment contract is drafted.
Further changes have also been made to certain exemptions in the termination payments legislation. In particular they remove foreign service relief but with an exemption for seafarers. Termination payments made on the occasion of injury are unaffected by the new legislation and remain tax exempt, however, the exemption does not apply to payments in cases of injured feelings.
The legislation splits an employee’s termination payment into two types of payment, specifically, payments that can still benefit from the £30,000 threshold and those that cannot.
The legislation works by first identifying any payments that should be treated as earnings and any remainder is then subject to the £30,000 exemption.
The changes are to be introduced in two phases:
• Phase 1 - Affecting employees from 6 April 2018, who will have to pay tax and Class 1 NICs on part of their termination payment.
• Phase 2 – Effecting employers from 6 April 2019, who will have to pay secondary NIC on the termination payment that exceeds £30,000.
Rules Until 6 April 2018
For termination payments made before 6 April 2018, PILON payments which were not contractual were considered as earnings and therefore not subject to tax and National Insurance deductions subject to a £30,000 income tax exemption. PILON payments made which were contractual were however treated as earnings and taxable. Other payments made i.e. damages for breach of contract were included in the £30,000 tax exempt amount.
Rules Applicable From 6 April 2018 [Phase 1]The new rules require the employer to identify the amount of basic pay that the employee would have received if they had worked their notice period, even if the employee leaves the employment part way through their notice period. The amount will be treated as earnings and will not be subject to the £30,000 income tax exemption.
Rules from 6 April 2019 [Phase 2]
An employer will be required to pay NICs on any part of a termination payment that exceeds the £30,000 threshold. This will be collected in ‘real-time’, as part of the employer’s standard weekly or monthly payroll returns and remittances to HM Revenue and Customs.
Prior to these changes, the rules for taxation of termination payments were viewed as being overly complex and it was considered that the exemptions may have incentivised some employers to take advantage of the rules by structuring arrangements to include payments that are ordinarily taxable to minimise the Income Tax and National Insurance due.
These measures are well received and should serve to bring an enhanced degree of fairness and clarity to the taxation of termination payments. Ultimately, it is anticipated that the tax and NICs consequences will be uniform for everyone insofar as they are no longer dependent on the manner by which employment contracts are drafted or whether payments are structured in some other form.
Disclaimer Please note that this commentary does not purport to be a comprehensive review of the UK Employment Termination provisions. Detailed professional advice should be taken before any particular transaction or action is taken in relation to these legislation changes.