Termination payments and tax – changes are approaching

The aims

• treat all payments in lieu of notice as earnings
• effectively, employers will be required to subject to tax an amount equivalent to the employee’s basic pay if and to the extent that notice is not worked
• subject all termination payments above the £30,000 threshold to class 1A NICs. This will be implemented in April 2019 which is later than the other changes which take effect in April 2018).
• permit HM Treasury to vary the £30,000 threshold by regulations.
• abolish foreign service relief (except in relation to seafarers) for UK resident employees.

What does this mean?

In essence, employers must treat a slice of a termination award, which reflects basic pay for any part of a notice period that is not served, as earnings, and subject that slice to tax and NICs (employer and employee).

This is a considerable change from the original position as it will no longer be sufficient to terminate in breach of contract and pay that payment as damages. Even in the circumstances where an employee is dismissed for misconduct and at a later date a settlement agreement is entered into, payment for notice will need to be allocated and subsequently subject to tax. Equally any payments by way of a salary sacrifice scheme will need to be included into the calculation for tax purposes.

What is a termination award?

Defined as a payment or other benefit received directly or indirectly in consideration of, in consequence of or otherwise in connection with the termination of a person’s employment.

However, termination awards do not include:

• statutory redundancy pay
• approved contractual pay (to the extent that it does not exceed the statutory redundancy pay).

The slice of the termination award that must be treated as earnings is:

• the entire termination award (disregarding statutory redundancy pay and approved contractual pay) if “post-employment notice pay” (PENP) is equal to or more than the termination award.
• PENP, if it is less than the termination award but is not nil.

How to calculate Post-Employment Notice Pay (PENP)

The calculation differs depending on a number of factors.

The basic formula for an employee who is paid monthly, whose contractual notice period is expressed in months and whose employment is terminated with immediate effect or whose unworked periods of notice is a whole number of months is: BP x D – T, where:

• BP is basic pay for the last pay period to end before the day notice is given (assuming notice is given)
• D is the number of months in the post-employment notice period (broadly the unworked periods of notice)
• T is amounts (other than holiday pay and termination bonuses) that are paid on termination but are taxable as earnings.

Example

Employee A is paid £3,000 monthly (basic pay) and has a 3 month notice period. A works one month of the three month notice period. A’s employer makes a termination award of £10,000.

Applying the formula: BP (3,000) x D (2) – T (nil) = £6,000.

As that is less than the termination award, £6,000 is treated as earnings and the balance is only taxable if it exceeds the £30,000 exemption.

However, if part of the termination award is a statutory redundancy payment, the termination award is reduced accordingly. For example, if £5,000 of the £10,000 termination award is a statutory redundancy payment, the termination award will be £5,000. As PENP in this example is £6,000, so greater than the termination award, only the £5,000 which is not statutory redundancy payment shall be treated as earnings.

When will the changes be effective?

Whilst the changes become effective from 6 April 2018, the change may affect some settlement agreements before 6 April 2018 because these rules apply from when the payment is made to the individual (not when the agreement is signed).

Changes to class 1A employer National Insurance contributions will be implemented from 6 April 2019.