Tax on termination payments – how are settlement agreements going to be affected?

If you are intending to give an employee a settlement agreement, and both the last day of their employment and the payment date are after 6 April 2018, you will need to consider the new tax reforms which are being introduced by the Finance Act (No.2) 2017.

Overview

In short, the idea is to treat all payments in lieu of notice (PILON) as subject to tax and class 1 NICs. 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. This is being termed post-employment notice pay or ‘PENP’.

At the moment, if there is no payment in lieu of notice clause in an employee’s contract, or such a clause contains a discretionary power to make such a payment and an employer chooses not to exercise this, a tax free damages payment may be made for lack of notice (assuming no custom and practice of taxing such payments is in place). It will no longer be possible to make such a payment in the same way when the tax changes come into force.

How is PENP calculated?

If the termination payment includes an element of PENP, this must be taken out before the remainder, if any, of the termination payment comes within the tax free exemption on payments of up to £30,000 on termination of employment (assuming of course that any other payments the termination payment includes are not taxable e.g. consideration for restrictive covenants.)

Whilst these provisions were originally intended to be brought in to simplify this area, there are a number of variants to the calculation depending on the type of contract the employee is on, how their notice period is defined and whether notice is given. The calculation is based on formula as set out in the legislation.

This is a complex area with a number of variants and it is recommended that legal advice is sought in individual circumstances.

What if the company intends to enforce a contractual PILON?

Even if you intend to enforce a contractual PILON as well as making a termination payment, you will still need to undertake a PENP calculation.

HMRC guidance is awaited as to what stage of the calculation the PILON payment should be taken into account in order to avoid double taxation as there are currently differing opinions on this. Further guidance is also needed on how to treat payments made following a gross misconduct dismissal where an employer is likely to believe that notice is not due.

Other Points to Note

It appears that contractual redundancy pay over and above statutory redundancy pay may not automatically be included within the £30,000 tax free exemption. Any amounts of statutory redundancy will, however, need to be taken out of the termination payment pot before PENP is calculated.

Given the complexities of the new reforms and the tighter rules on the taxation of payments in lieu of notice, it is now going to be more costly for employers to enter into settlement agreements and these costs should be kept in mind when negotiating employee exits.

If you require any assistance drafting settlement agreements or advice on the exit of an employee, please contact our settlement agreements team.

This content is correct at time of publication