New regime for taxation of termination payments now in force

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The following changes to the way payments on termination of employment are taxed come into force today, 6 April 2018:

  • As explained further below, all payments in lieu of notice are to be treated as earnings subject to tax and class 1 (employer and employee) NICs
  • Payments for injury to feelings connected to termination fall outside the exemption for injury payments, except where the injury amounts to a psychiatric injury or other recognised medical condition
  • Foreign service relief for UK resident employees is abolished (except in relation to seafarers)

Of the above changes, the one that will have the greatest day-to-day impact on employers is the change to the taxation of payments in lieu of notice. The new rules apply wherever an employee’s employment terminates on or after 6 April 2018, and the employee is not working out their entire notice period.

Under the new rules, income tax and NICs must be paid in relation to any payment in lieu of notice, (regardless of whether there is a contractual right to pay in lieu or not). An employer making a relevant termination payment to an employee (effectively, any payment or benefit which compensates that employee for the ending of their employment, other than any statutory redundancy payment), is required to carry out a calculation, following the formula set out in the new section 402D of the Income Tax (Earnings and Pensions) Act 2003, to identify the amount that the legislation deems to be “Post-Employment Notice Pay”, referred to as PENP.

Broadly speaking, PENP is supposed to equate to the basic salary the employee would have received during any unworked period of notice, although the quirks of the formula mean that the amount deemed to be PENP will not necessarily be what the employer or employee would have expected. PENP is always subject to tax and NICs.

Any remaining balance of the relevant termination payment, over and above PENP, can be paid free from tax and NICs up to £30,000. Any additional balance over £30,000 will be subject to income tax, but remains payable free from NICs (although, from 6 April 2019, such payments will become subject to employer – but not employee – NICs).

This change will be of particular relevance when employers are negotiating settlement agreements with departing employees, as the PENP calculation is likely to mean that more of the termination payment will be taxable than would have been the case under the previous rules. The formula for calculating PENP is complicated, and employees will understandably be keen to know exactly how much of their termination payment will be taxed, and how much they will end up with in their pocket at the end of the day.

We have added some guidance on the PENP formula to the Resources and Knowledge section of our website, to aid employers’ understanding of the new rules. However, given the formula’s complexity, we strongly recommend that employers consult their payroll department – and potentially also seek external tax advice – when setting out the details of termination payments in settlement agreements going forwards.

Author

Senior Legal Adviser

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