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Changes to taxation of employment termination payments

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The current tax and National Insurance treatment of payments made on the termination of employment has received criticism for being too complicated.

Due to this, the Government has announced that change is on the horizon, and these changes are expected to take effect from April 2018.

What is the current position?

At   the   moment,    employees   who   are   paid a genuine termination payment  for loss of employment, often  via a settlement  agreement, are  entitled  to  receive  up  to  £30,000 of  that termination payment   free  from  deductions  of tax and National Insurance  Contributions.

To qualify for the £30,000 exemption, the payment must be a genuine ex-gratia payment. In other words, not a contractual payment.

One area that often causes issues is payment in lieu of notice pay.  Does payment in lieu of notice pay fall within the £30,000 exemption? The answer depends mainly on how the contract of employment   is structured. If  the  employer reserves the right to pay in lieu of notice  in the contract (what  is often  called  a PILON),  then the  pay  in  lieu  of  notice  will  not  fall  within the  £30,000  exemption and  should  be  taxed. If there is no PILON clause, it will likely fall within the exemption and can be paid tax-free.

This would only not be the case if there was a custom and practice of paying in lieu. The reason for the difference is where there is a PILON, the payment is contractual. Where there is no PILON it is not contractual.

In our   experience,   many   employers   are   not aware of this distinction. Some pay tax when they do not need to and others pay it tax-free when they should not.

What is staying the same?

The    Government   has    proposed   to    keep the £30,000 figure as the tax-free limit for termination payments.

What is going to change?

From   April 2018,   HMRC is going to treat all contractual and non-contractual PILON’s equally, which will take away the uncertainty.

In essence, this means that if you are paying an employee’s notice period, such a payment will attract tax and National Insurance contributions irrespective of whether or not there is a PILON in the employee’s contract of employment.

Currently, compensation payments in excess of £30,000 attract tax but not National Insurance contributions. From April 2018 this is proposed to  change  and  any  excess above  £30,000  will also be subject  to employer  National Insurance contributions.

Also from  April  2018,  payments  for  injury  to feelings  will  only  be  exempt  from  tax  if they relate to a psychiatric  injury or other recognised medical condition.

What do you need to do now?

The benefit that employers and employees can potentially currently receive from leaving out PILON clauses from contracts of employment will go once April 2018 rolls around, due to all PILON payments being treated the same from a tax point of view.

As a result of this, we would recommend that PILON clauses are included in all contracts of employment.

There are many benefits to including a PILON clause   including    the   quick   removal    of   an employee without risking a breach of contract claim. If you pay in lieu of notice without having a PILON, there is a technical breach of the employee’s contract of employment as there was no contractual right to do so.

You  must  remember  that,  if an  employee  has restrictive  covenants  in their  contract and  you breach  their  contract, then  they will effectively be set free from  these restrictive  covenants  and so it is really important that  you abide by their contract in this instance.

Always check termination payments

This note is only intended to be a summary of the rules in this area. When making termination payments   it is always   advisable   to seek tax advice

If you would like any further advice on any aspect of employment law, please contact a member of the team on 01332 227596 for a confidential chat.

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