The core rules for taxing termination payments have changed little in the past 20 years save for the occasional tax case on contentious areas. However, that does not mean that they are well understood and the Office of Tax Simplification rightly identified the treatment of termination payments as an area ripe for simplification.
The Government has finally published its draft legislation following the consultation and OTS recommendations, with changes coming into effect from April 2018, the aim being to make the system simpler and fairer.
What changes are being made?
As published, the draft legislation contains some significant changes to how both income tax and NICs Contributions apply to termination payments. The headlines are:
- All PILONs will be treated as earnings and subject to income tax and NICs regardless of whether or not there is a PILON clause in the employee's contract of employment. Currently non-contractual PILON payments can be made free of tax and NICs.
- Termination payments over £30,000 will be subject to employer (but not employee) NICs.
- Payments apportioned to cover "injury to feelings" will be excluded from the general exemption for injury payments, except where they relate to a psychiatric injury or a recognised medical condition. This will remove the current conflict in case law we have on this issue.
- The current tax exemption for employment outside the UK (the foreign service exemption) will be abolished, except in relation to seafarers.
All PILONs to be treated equally
Currently, contractual payments made in lieu of notice (PILONs) are taxed as earnings whereas genuine non-contractual PILONs, which are not paid by the employer as an automatic response to termination, are not. The present system often requires scrutiny of employer custom and the PILON-payment decision in order to determine the tax implications.
Under the new legislation, this contractual/non-contractual distinction will be removed. All PILONs will be taxed as earnings and will be subject to income tax, employer national insurance contributions (NICs) and employee NICs with the PILON amount reducing the £30,000 tax free threshold.
Other payments received during notice to be taxable
As well as notice payments, any other post-employment payments (such as expected bonus income) that would have been treated as earnings if the employee had received them during the notice period will be taxed. This will apply even if the employee does not work out any or all of the notice period and involves a complicated calculation with the amount being deemed as falling under this part of the legislation reducing the £30,000 tax free limit accordingly.
Currently, the proportion of a termination payment above £30,000 is subject to income tax only and is free of employer and employee NICs.
The consultation response explains that the rules on income tax and employer NICs are to be aligned. From April 2018, the excess above £30,000 will also be subject to employer NICs. However, the whole termination payment will remain outside the scope of employee NICs.
This change will make terminations more expensive for employers and they will need to ensure they take the employer NICs cost into account when making termination payments post April 2018.
Maintaining the status quo: the £30,000 threshold
The consultation sought opinion on whether to introduce a variable threshold for the payment of income tax and NICs. The suggestion was that this could be linked to the employee's length of service, coupled with the introduction of various new exemptions. These proposals have been put to one side in favour of maintaining a clear threshold figure.
It is worth noting that the £30,000 threshold has not changed since it was set in 1988 and so it could be suggested that this should be updated to reflect inflation but for now the government is maintaining the £30,000 threshold.
Termination payments of up to £30,000 will remain exempt from income tax and employer NICs and employees will continue to benefit from an unlimited NICs exemption on termination payments. These exemptions will apply to any balance remaining after notice payments and other taxable payments have been taken into account and taxed accordingly. For genuine termination payments, this maintains the current position and is motivated by the government's wish to support those who lose their job.
Payments for injury to feelings to be excluded from the injury exemption
Under the current system, there are various exemptions, reliefs and reductions that apply to termination payments in addition to the £30,000 threshold. Qualifying payments have no income tax liability even if it they are over £30,000.
One such exemption is for payments made because of the death, disability or injury of the employee. Divergence of judicial opinion on whether payments for injury to feelings fall within this exemption has left the current position in a state of uncertainty.
HMRC has clarified its own understanding of the current legislation: "the exemption does not apply in cases of injured feelings. In order for the exemption to apply there must be 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." As a result, the government plans to amend the legislation to make clear that the exemption does not apply to payments for injury to feelings.
Foreign Service Exemption
The final change in the rules is the removal of Foreign Service relief which currently exempts termination payments from tax and NICs where an employee has worked wholly overseas, or partially exempts the payment if the employee has worked both overseas and in the UK for the employer.
From April 2018 termination payments will be taxed as a lump sum at a single point in time so termination payments for employees who have worked overseas but who are subsequently made redundant in the UK will be subject to tax in the UK to the extent the payment exceeds the £30,000 exemption limit. The NIC treatment will depend on the coverage in place at the time of the termination.
What does this mean for employers?
Although some of the more complicated proposals have been dropped from the draft legislation, the changes do not quite mean the end of complicated termination payments.
Employers should be aware that the changes are likely to make terminations more costly. The reasons for this are twofold. Firstly, the changes to the treatment of PILONs and compensation payments above £30,000 will increase liability to employer NICs. Secondly, increased financial packages may have to be offered to exiting employees to counter the lower net figure the employee is likely to receive under the new regime.
As the employee's liabilities to income tax and employee NICs will also expand following the changes, employers will wish to take extra care that a robust tax indemnity is put in place on termination.
Over the coming months we can expect the inevitable ironing out of the draft legislation's wording but it does leave the question as to whether simplification has actually been achieved or if this is just a change in the legislation to benefit HMRC. However, the end result and impact should remain much as set out above; one to keep on your radar ahead of April 2018.For more information or advice on how this could impact your business contact Charlotte Stewart, Integrated Employment Solutions Manager, firstname.lastname@example.org