Termination payments taxed differently from 6 April 2018 | What do employers need to know and do?

Written on 10 Apr 2018

Significant changes to the taxation of termination payments apply from 6 April 2018. In summary, the new rules treat all employment contracts as though they contained a payment in lieu of notice ('PILON') clause, so that the basic pay the employee would have received during the notice period will now be taxed as earnings (subject to income tax and employee's and employer's National Insurance Contributions ('NICs')). A statutory formula is used to calculate the part of a termination payment which must be treated this way.

Changes apply where both employment ends and payment is made on or after 6 April 2018

Clarifying what has been a grey area, HMRC has confirmed that the new rules apply to payments or benefits received on or after 6 April 2018 in circumstances where the employment is also ended on or after 6 April 2018.

Understanding new terminology: Post-Employment Notice Pay

The part of the termination payment which under the new rules is treated as being a payment in respect of the employee's notice period and subject to the new rules (i.e. subject to income tax and employee's and employer's NICs) is called 'the Post-Employment Notice Payment' (PENP).

Calculating PENP

PENP is calculated by applying a statutory formula which essentially multiplies the employee's daily basic pay rate by the number of days in the 'Post-Employment Notice Period' before deducting any amounts which have been paid to the employee in connection with termination and which are taxable as general earnings (but excluding accrued holiday or termination bonuses).

Statutory formula

((BP x D)/P) – T = PENP


BP = basic pay in the last pay period (the period in which the employee is regularly paid) before the trigger date (i.e. the date notice is given or the last date of employment if no notice is given)

D = number of days in the post-employment notice period (i.e. the period between the last day of employment and the earliest lawful termination date – the last date in the period beginning on the trigger date and lasting as long as the minimum notice the employer is required to give to terminate employment).

P = number of days in the last pay period

T = amounts paid in connection with termination and which are taxable as general earnings (but not including accrued holiday or termination bonuses).

Note that a slightly different formula applies in certain circumstances where the employee is paid monthly  and the minimum notice period and the post-employment notice period can be expressed as a whole number of months – in this case, the number of months can be used in the formula instead of days.

What is basic pay for PENP purposes?

Basic pay for PENP purposes is the employee's employment income, excluding:

  • overtime pay, bonuses, commission payments, gratuities and allowances;
  • any amounts paid because of the termination of employment (e.g. retention bonuses);
  • the value of benefits in kind;
  • various specified amounts treated as earnings (e.g. sickness and disability payments and payments for restrictive covenants);
  • amounts which count as employment income under the employment-related securities regime (e.g. shares and options); and
  • the value of employment related securities that are general earnings,

but including amounts given up by the employee, but which would have been earnings had they not done so (e.g. salary sacrifice).

Putting the new rules into practice: example

Andrew is given notice by XYZ Ltd on 5 June 2018.  Andrew and XYZ Ltd agree that the last date of employment will be 30 June 2018.  Andrew has an annual basic salary of £48,000, which is paid at the end of each month and he is also entitled to a non-contractual 10% bonus, paid on 31 May each year. The employment contract requires XYZ Ltd to give Andrew 3 months' notice to terminate employment.  The employment contract does not contain any PILON clause.  XYZ Ltd agrees to pay £10,000 as an ex-gratia amount in consideration of the employee entering into a settlement agreement, £8,000 for loss of notice and £2,000 for accrued holiday pay.

On these facts Andrew's PENP is £8,645.16, calculated as follows:

((BP x D)/P) – T = PENP

(£4000 x 67 days)/31 days - £0 = £8,645.16


BP = basic pay of £4000 (the employee is paid monthly so £48,000 divided by 12 months. The 10% bonus is excluded from basic pay)

D = number of days in post-employment notice period, which is 67 days (the number of days between 30 June 2018 and 5 September 2018 where 30 June is the last day of employment and 5 September is the earliest lawful termination date i.e. 3 months on from 5 June 2018 when notice is given).

P = number of days in the employee's last pay period, which is 31 days (the employee's last pay period was May which has 31 days).

T = amounts payable in connection with termination and taxable as earnings, which is £0 (no amounts have been paid in connection with termination that are taxable as general earnings.  The 10% bonus and £2000 for accrued holiday pay are excluded)

So how is the total termination payment of £20,000 paid to Andrew taxed under the new rules?

The total termination payment of £20,000 is therefore taxed under the new rules as follows:

  • £8,645.16 is PENP and so taxable in full (i.e. subject to income tax and NICs);
  • £2,000 is accrued holiday pay and so taxable in full (i.e. subject to income tax and NICs); and
  • £9,354.84 is an ex-gratia payment which can be paid tax free as it is below the £30,000 threshold.

Will employers always need to apply this formula to any termination payment?

We await publication of guidance by HMRC on the new rules, but for now this would seem to be the safest course of action, unless of course the employee works their notice period out in full.  Even if the employee is paid in lieu of notice under a contractual PILON, there is a risk that the PILON payment may be different from the PENP calculation – for example, the PILON payment may not take account of any salary sacrifice.  However, in these circumstances, any PILON which has already been paid is taken into account in the statutory formula coming under the deduction 'T'.

What do employers need to do now?

For any termination payments made to employees on or after 6 April 2018 where the employment also ceases on or after 6 April 2018, employers will need to ensure such payments are taxed correctly under the new regime.  The new rules will generally cost the employer and employee more, with additional charges to income tax and NICs. Employers will need to factor this into termination discussions accordingly.

Employers may also wish to consider amending the terms of any standard employment contract to include a PILON clause, as the primary reason for not including such a clause (i.e. to get a tax advantage for payments made on termination) will no longer be applicable. Instead, an employer can take advantage of using a PILON clause to potentially terminate the employment contract without having to allow the employee to work out their notice.  Terminating without full notice may otherwise put the employer in breach of contract meaning any post-termination restrictions which might otherwise be relied on may be ineffective.

Please do not hesitate to contact your usual Osborne Clarke contact to discuss the new statutory formula and any of these points further.