Update on the changes to the taxation of termination payments

Background

A series of reforms have been introduced to the taxation of termination payments from 6 April 2018 following technical consultation. Although the reforms started out as simplification measures, they now “clarify and tighten” the taxation of such payments. In other words, the legislative changes effectively enlarge the scope of taxation of termination payments.

Position prior to 6 April 2018

Termination payments (which were not taxed under any taxation provisions) made to employees as compensation for loss of office were free of income tax and national insurance contributions up to £30,000.

The tax treatment of a PILON (payment in lieu of notice) depended on the contract of employment. If the employment contract provided for the employer to make a PILON, then the PILON was fully taxable. Conversely, if the employment contract made no provision for PILON, a PILON payment effectively constituted a payment of damages for breach of contract and could therefore be paid tax-free up to £30,000.

Foreign Service Relief was available to employees who have spent periods working abroad and were non-UK tax resident for part of the period covered by the termination payment. The Foreign Service Relief is effective after taking into account the £30,000 exemption.

Position from 6 April 2018

All PILONS, whether or not there is a PILON clause in the contract of employment, are taxed as earnings.

Termination payments are now split into two elements: (a) Post-Employment Notice Pay (“PENP”), and (b) the remaining balance. PENP represents the amount of basic pay the employee would have received had their employment been terminated with full and proper notice being served, to be determined by a statutory formula. This is subject to income tax and NICs.

The remaining balance, to the extent not subject to tax as remuneration or payment for restrictive covenants, is considered for tax relief (as statutory redundancy payment or compensation for loss of office, etc.). The £30,000 exemption is still available to relieve against the payment of the remaining balance. Any payment in excess of the £30,000 (“Excess Remaining Balance”) is subject to income tax but not national insurance contributions (NIC) as was the case prior to
6 April 2018.

The exemption from tax for payments for injury and disability does not apply to injury to feelings, whether on or before termination of employment, except where the injury amounts to a psychiatric injury or other recognised medical condition.

Foreign Service Relief has been removed for employees who are tax resident in the UK in the year in which their employment is terminated. However, the Foreign Service Relief continues to be available for employees who are non-UK resident in the year of termination.

Changes from 6 April 2020

Another significant proposed change to the taxation of termination payments is the alignment of income tax and NIC liabilities.

The government had announced that the NIC legislation would be changed so that employer’s Class 1A NIC would apply to the Excess Remaining Balance (see above). This change was initially intended to take effect from 6 April 2019.

The government recently announced that this major change will be delayed and will now take effect from 6 April 2020.

For further information contact Michael Landon.

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