Termination payments – changes to how they are taxed from April 2018

Written on 19 Sep 2016

The government
has published its response to last year’s consultation on simplifying the tax and
NICs treatment of termination payments, as it seeks to achieve a ‘simpler
and fairer’ system. We review below the changes set out in the response and their practical implications. In terms of actions arising, for now, employers should be aware that changes to the taxation of termination payments will apply from April 2018, and look out for our further updates on developments.

Ending manipulation and complexity

The government views the current system as ‘complex’ and open to ‘manipulation’ by employers to take advantage of the employer NICs exemption’.

Under the existing rules, a genuine payment for loss of employment can be paid free of employer and employee NICs. The first £30,000 of the payment can also be paid free of income tax. If a payment falls within the exemption, employers can use this as a negotiating tool in termination discussions.

An end to employer NICs advantages

Under the government proposals, from April 2018 a termination payment which falls within the income tax exemption can only be paid free of employer’s NICs up to the first £30,000 (to bring it into line with the current income tax exemption). To the extent that the payment exceeds £30,000, income tax and employer NICs will be payable.

What does this mean in practice? The additional employer NICs will mean an increased charge for employers, but in reality this may be passed on to employees indirectly via a reduced termination payment.

There will, however, continue to be an unlimited employee NICs exemption for payments relating directly to the termination of employment, so there will not be complete alignment of the income tax and NICs position. The stated intention of this is to be fair to employees who are losing their jobs.

Curtailing the exemption – more termination payments to be taxable and charged to NICs in full

Payments in lieu of notice or ‘PILONs’ are seen as the culprits for much of the existing ‘manipulation’ and ‘complexity’. Taxing a contractual PILON is relatively straightforward – it is subject to tax and NICs in full. But, if the contract is silent, questions arise as to whether there is in fact a fully taxable ‘implied’ PILON or indeed, the HMRC concept of an ‘auto’ PILON; or whether a payment is true compensation for loss of employment, benefitting from the £30,000 exemption.

To bring clarity to this grey area, the government is proposing to take the PILON debate out of the equation. It proposes that, from April 2018, all PILONs will be subject to income tax and employer and employee NICs as earnings. It will no longer matter whether a PILON is contractual, implied, auto or truly non-contractual.

Under the new rules, any payments which would have been treated as earnings, if the employee had worked their notice period, will also be subject to income tax and employer and employee NICs. This captures not only any payment relating to the salary an employee would have received, but also some benefits and expected bonuses.

On the face of it, the new regime seems straightforward. However, the draft legislation which has been published is complex, requiring an employer to apply statutory formulae and new definitions to determine the different constituents of the termination payment which will, in turn, dictate the tax and NICs due. It is hoped that the next draft of the legislation, to be published next year, will better achieve the government’s objective of simplification.

Aside from this new complexity, employers may again be tempted to pass on any additional costs resulting from these rules to the departing employee, potentially leading to fewer amicable settlements and an increase in litigation.

No exemption for “injury to feelings”

The government has also confirmed that from April 2018, a payment on termination for ‘injury to feelings’ will not fall within the exemption from tax and NICs for payments made because of death, disability or injury. The government is making this change to clarify the position, in response to recent conflicting case law. The exemption will only apply where is an injury or disability of a physical or psychological nature that is sufficient to cause the employee to be unable to perform his or her job properly.

A payment made for injury to feelings for discriminatory acts which take place prior to termination of employment remains outside these reforms and can continue to be paid free of income tax and NICs.

Modern global workforce renders foreign service relief outdated

The government has also determined that the current ‘foreign service relief’, which reflects the fact that an individual has been working abroad, has become outdated and unnecessary. Accordingly, this exemption will be removed from April 2018.

A fairer and simpler system?

Whilst the proposals do arguably bring more consistency, whether they herald a ‘simpler’ and ‘fairer’ system is perhaps open to debate – the consultation on the draft legislation (which closes on 5 October 2016) is intended to ensure that the new provisions fulfil the government’s stated policy objectives, and the specific drafting is likely to be refined.