Taxation of Termination Payments Reform – What Does It Mean for Employers?

On 24 July 2015, the Government launched a consultation as to how termination payments are treated and, during August 2016, released draft legislation outlining its proposed changes.

The Autumn Statement, delivered by the Chancellor of the Exchequer on 23 November 2013, served as a reminder of some of the Government’s recommendations.

Currently, where there is a provision in an employee’s contract of employment which allows the employer to terminate his/her employment immediately by making a payment in lieu of notice (PILON),  any such payment will be taxable and subject to national insurance contributions (NICs).

Otherwise, where there is no express provision in the employee’s contract, the position can be more ambiguous.  If an employee’s contract of employment is silent on this issue and there is no discretionary or other right to a PILON, it can be possible in some circumstances for this payment to be treated as damages and paid without any deductions. However, the position in this respect depends on the specific facts of each matter. Accordingly, whether employers can pay notice payments tax free often becomes a point of contention when severance terms are being negotiated.

Notwithstanding the above, at present, employers may be able to pay non-contractual payments in connection with the termination of employment up to a value of £30,000 free from deductions and above this sum, only income tax is payable.

There are also numerous tax exemptions for particular types of payments, including in relation to injury, disability or death, for foreign service relief in relation to employment performed outside the UK, and for the armed forces.

From April 2018, in an attempt to eliminate the confusion which often arises with termination payments, it is intended that the distinction between contractual and non-contractual PILONs will be removed. Accordingly, moving forwards, all PILONs (regardless of the employee’s termination date) will be treated as earnings subject to income tax, employer and employee NICs.

It has also been suggested that payments which an employee would ordinarily receive during their notice period and would normally be taxable (such as bonus payments), will now also be subject to tax under the terms of a settlement agreement.

Furthermore, employers’ NICs will be payable on compensation payments that are above the £30,000 tax free exemption (whereas, currently, termination payments of any value are exempt from NICs).

Finally, it has been proposed that payments for injury to feelings will fall outside the exemption for injury payments (except where this amounts to a psychiatric injury or a recognised medical condition) and foreign service relief, in relation to employment outside of the UK, will be abolished (except in relation to seafarers).

Lisa Moore comments: “The Government initially proposed removing the £30,000 tax-free allowance altogether so, comparatively, the above reforms are likely to be received as welcome news by employees and employers alike. Although the proposals will provide more clarity for employers when formulating settlement terms, this is likely to come at a cost. Employers may well find themselves having to increase termination payments to compensate for making the PILON on a net basis and will have less flexibility when proposing settlement packages.”

If you would like to discuss any issue or query arising from this update please contact Lisa Moore or your usual contact in the Employment team on 0121 233 4333. Alternatively, email us at [email protected].