14 September 2016

Tax on termination payments: the devil in the detail

This article was written by Tamsin Rickard, Professional Support Lawyer

The government has commenced a consultation on the details of its proposed changes to tax treatment of termination payments. 

Changes to taxation of termination payments have been heavily trailed for some time and in this year’s Budget the government announced that these would come into force in April 2018.

Some key elements will remain unchanged:

  • the exemption from income tax on the first £30,000 of a termination payment will remain; 
  • any payment to an employee that relates solely to the termination of the employment contract will continue to have an unlimited exemption from employee national insurance contributions (NICs).

However, the following changes will come into force from April 2018:

  1. termination payments that are subject to income tax on amounts in excess of £30,000 will be subject to employer NICs (whereas now, they are exempt from both employer and employee NICs);
  2. all payments in lieu of notice (“PILON”) and certain damages payments that would have been earned or have been paid had the employee not been dismissed will be taxed as earnings (see further below);
  3. the exemption for payments relating to injury will not apply in cases of injured feelings unless they amount to a psychiatric injury or other recognised medical condition;
  4. the foreign service exemption will be abolished. 

The draft regulations include a complex new mechanism setting out the detail of point 2 above.  In summary, the regulations provide that the tax-free allowance will continue to apply to redundancy and unfair dismissal awards, but that other termination payments are subject to a more complex and, in many cases, less generous analysis to determine tax treatment.   A detailed summary is beyond the scope of this article, as the regulations are only in draft at this stage.  However, if implemented in their current form, the regulations will create a complex statutory deeming mechanism that will categorise parts or all of termination payments as taxable earnings, under the new concepts of “post-employment notice income” and “expected bonus income”.  For example, the mechanism allows HMRC to allocate part of a termination payment as attributable to a notional bonus payment (which will be taxable under the new rules) to the extent a bonus would have been made during the employee’s notice period, even where, as is common, the employment contract expressly provides that bonuses are not payable once notice is served.  This is irrespective of how the termination payment was actually calculated. The overall effect is likely to be a significant limiting of application of the £30,000 exemption.

What does this mean for employers?

Many employers will be relieved that the £30K exemption has survived, albeit subject to some changes. The exemption plays a vital role in aiding settlement of many employment disputes: in effect, it allows more money from an agreed settlement sum to reach the hands of the employee without additional cost to the employer and, in doing so, forms a vital bridge between the parties in resolving disputes by way of settlement.

However, the devil is in the detail of these changes.  The new statutory mechanism for taxing “post-employment notice income” and “expected bonus income” appears to be intended to increase tax take on settlement payments, by giving many termination payments taxable status at least in part, especially where bonuses would have been received had employment continued.  Moreover, in many cases the calculation of these sums will be far from straightforward; how is an employer to value a discretionary bonus which might (or might not) have been awarded during a notice period? And will HMRC dispute that valuation?  This is likely to be particular significant in the case of relatively modest settlements, where the benefit of the £30,000 tax exemption may be reduced or even lost altogether.

The changes to employer NICs will also increase the cost of settlements to employers in many cases, and, as the consultation document states, it could "have a knock-on impact on employees who could end up bearing the cost through reduced pay-outs".

The blanket treatment of PILON payments as taxable will also be significant: currently, PILON payments are not taxable where there is no PILON clause (express or implied) in the employment contract, which can be a valuable exemption. The change will certainly simplify this area, but at the expense of another potential saving to the overall cost of a termination package.

Similarly, the removal of the injury exemption from injury to feelings cases will reduce one avenue for tax-efficient payment structures in cases of alleged discrimination where there could be grounds for an injury to feelings award.  However, the taxation of such injury to feelings payments had already been thrown into question by recent court decisions; this change will finally clarify the position.

The cumulative effect of these changes could be significant: whilst the headline is the survival of the £30K exemption, employers may find that reaching a settlement with departing employees after April 2018 will be tougher - or at least more expensive.  As that date approaches, it may be worth taking these changes into account and seeking expert advice in case departures can be accelerated to enjoy the benefit of the current rules.  We will keep you posted.

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