Legal-ease: Changes to the taxation of termination payments

The government has released draft legislation on proposed changes to the taxation of termination payments

When the government first consulted on changes to the taxation of termination payments, the removal of the £30,000 tax-free threshold was proposed in favour of a significant reduction in tax-free income available, possibly on the basis of length of service. Following the consultation the government has set these plans aside and, instead, opted to retain the £30,000 tax-free allowance for non-contractual payments, which is good news for employers and employees.

A change related to the tax-free element of termination payments is that employers’ NICs will now be paid on compensation payments that are above the £30,000 tax-free amount. For example, if compensation of £45,000 is paid the first £30,000 is tax free but the remaining £15,000 will be subject to both income tax and employers’ (but not employees’) NICs.

Changes will also be made to the treatment of pay in lieu of notice (PILON) payments. Under the rules, where an employment contract permits the company to make a PILON, HMRC treats these payments as earnings and they are subject to income tax and NICs. However, non-contractual PILON payments are not subject to tax and NICs because they are classed as compensation.

The government believes treating contractual and non-contractual pay in lieu of notice differently is confusing, unfair and open to abuse. It has proposed that the distinction is removed and all PILON payments will be taxable from April 2018. While this removes any confusion between whether tax should or should not be paid, the impact on employers is that the cost of termination packages will increase.

In addition, any other payments that the employee would have received and would have been taxed on (had they worked their notice period) will now be taxed on termination. The type of payments that would fall into this category would be expected bonus payments.

The draft legislation has been published and the government has asked for responses to the proposals by 5 October 2016, with a proposal for the legislation to come into force in April 2018.

The impact of the changes will be that terminating employment contracts will become more expensive for employers because of the need to pay employers’ NI contributions and taxation of all PILON payments. Employers may find themselves having to increase termination payments made to exiting employees to compensate for a lower net figure on their termination.

HR professionals should take time to consider the long-term plans and strategies of the business in the lead up to April 2018. If your organisation has any proposed restructures that intend to utilise employee exit packages it may be prudent to deal with these issues sooner rather than later.

Sarah Dillon is a director at ESP Law, which provides HR magazine’s HR Legal Service