Taxation of Termination Payments from 6 April 2018

In limited circumstances, Employers have previously been able to add an incentive for employees considering settlement agreements by paying in lieu of notice (PILON) without attracting tax and national insurance contributions. In a bid to close this perceived loophole, the tax rules have changed as of 6 April 2018.

Changes as of 6 April 2018

If a contract of employment did not enable the employer to pay in lieu of notice (e.g. the contract was silent on the point) any PILON payment would be a breach of that contract. This was historically used by employers to designate the payment as compensation for breach of contract rather than a payment under it and thereby seek to exclude it from being subject to tax and national insurance contributions.

There are two methods for calculating tax due on a PILON payment:

1. in accordance with the notice and pay due under the contract of employment (the contractual method)
2. by following the calculation in s.402D of the Income Tax (Earnings and Pensions) Act 2003 (the statutory method).

In order to calculate the precise amount of tax payable, employers need to apply both the statutory and contractual methods and pay tax based on whichever is higher.

In the majority of cases, the two methods will have the same result however there are instances in which they can differ. For example, in the case of a salary sacrifice, the contractual method would frequently be based on the salary after the sacrifice; the statutory method requires the employer to disregard the sacrifice, resulting in a higher taxable payment.

Conversely, an employee’s contract might provide for other elements, such as cash equivalent of any benefits, to be included in any PILON payment. Base salary under the statutory method is calculated on the previous pay period so is likely to exclude cash equivalent of benefits. The contractual method would therefore require a larger payment to the employee and a larger tax contribution. Failing to follow the contractual method could amount to a breach of contract which might entitle an employee to evade their contractual confidentiality or competition obligations.

Summary

Accounts and payroll teams are likely to have implemented these changes however HR professionals should also be aware of the implications of the new regime. In the process of negotiating settlement agreement terms, an employee’s main concern is often the tax treatment of the payment. It make negotiations difficult if an employee is promised one tax treatment but tax is then applied in a different way.

The above is intended to provide an awareness of the changes made as of 6 April 2018 and is a generic summary only. You should seek independent financial advice and/or check the position with your payroll department for individual cases, each of which will be different.

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