Taxation of termination payments: Government confirms 2018 changes

The Government has released a consultation response document setting out its intention to take forward the reform of the tax treatment of termination payments and consulting further on the detailed implementation of its reforms. The consultation contains detailed legislation to implement the changes with effect from April 2018.

The main changes will include removing the distinction between contractual and non-contractual PILONs (payments in lieu of notice) to treat both as fully taxable earnings, treating all other payments which cover part of the contractual entitlement (including the notice period, even if the employee does not work it) as taxable earnings and levying employer National Insurance Contributions (NICs) on other termination payments above the £30,000 limit.

Background

The Government recognises that the rules governing the taxation of termination payments are complex. In addition, the Government is concerned that the rules can encourage manipulation by employers to take advantage of the employer NICs exemption, by changing the nature of some payments so that they become termination payments, including remuneration such as bonuses which would normally be subject to tax and NICs.

As a result, the Government published a consultation document in July 2015 proposing changes to the treatment of termination payments for tax purposes. The changes proposed largely followed the recommendations contained in the OTS review of employee benefits. In Budget 2016, the Government announced that it would retain the £30,000 exemption for amounts taxable as termination payments but would take forward the reforms from April 2018.

£30,000 exemption

Subject to the restrictions described below, the Government has decided to retain the £30,000 exemption for certain termination payments. There was little support for reducing the level of the exemption and the Government was reluctant to increase the level of the exemption (despite the fact that it has remained the same since 1988), given the additional Exchequer cost. In addition, there was little support for making the level of the exemption dependent on other factors, such as length of service. Maintaining the current £30,000 exemption was seen as striking the right balance, therefore.

Contractual and non-contractual payments

In the 2015 consultation, the Government proposed to treat contractual (eg contractual PILONs) and non-contractual termination payments (eg damages and non-contractual PILONs) in the same way. By removing the distinction, all payments made in connection with termination of an employment would be “earnings” and subject, in principle, to income tax and NICs.

The 2016 response document confirms that the Government will take this approach forwards as regards PILONs. The Government will remove the distinction between contractual and non-contractual PILONs. The majority of respondents supported removing the distinction and the Government believes this change will provide more clarity and certainty.

However, the Government has decided not to remove the distinction between contractual and non-contractual termination payments generally. The Government’s opinion is that the distinction remains useful and is not generally found to be complex. As a result, in order to determine which post-employment payments (or proportion of a payment) will be subject to the £30,000 exemption, employers will need to refer to the employee’s underlying employment contract and other terms and conditions. Any payment that covers part of the existing contractual entitlement, including the notice period even if the employee does not work it, will be taxed and subject to Class 1 NICs as earnings. Anything that is non-contractual will be the termination payment which will be taxed and subject to employer NICs on any amount that exceeds the £30,000 threshold.

Whilst the intention of the proposal is clear, compromise agreements that include payments covering a notice period where there is no right to pay a contractual PILON would not normally identify any payment related to the notice period not worked. As such, the draft legislation included in the consultation response document seeks to identify and charge to tax an amount of the termination payment on the basis that the employee had worked their notice period (regardless of what actually happens) using average figures for earnings. An anti-avoidance provision to prevent artificial reductions in earnings in anticipation of a termination is included.

NICs

Under the current rules, income tax is due on termination payments above £30,000 but there is no NICs charge. The consultation response document confirms that the Government will impose employer NICs on all termination payments if they are also subject to income tax. However, the employee NICs exemption on termination payments will remain unchanged.

Additional exemptions

The 2015 also consulted on the additional exemptions that currently apply to termination payments, even where they exceed the £30,000 limit, provided they are not contractual. The consultation response document confirms that the Government will retain the following exemptions when payments are made:

• because of the death, disability or injury of the employee
• under a tax exempt pensions scheme
• to a registered pension scheme
• for liabilities and indemnity insurance
• to HM Armed Forces
• by a foreign government, and
• in respect of certain legal costs.

However, the Government intends to amend the exemption for “injury” related payments to make it clear that it cannot apply to “injury to feelings”. In order to apply, there must be an injury or disability of a physical or psychological nature that is sufficient to cause the employee not to be able to perform his or her job properly. It appears, however, that payments for injury to feelings made during the employment, which would normally escape tax, will not be affected. As such, the change may put a person suffering such treatment during termination at a distinct disadvantage compared to a person who suffers the same treatment during the continuance of an employment.

In addition, the Government will remove the existing foreign service relief (which allows termination payments for certain qualifying individuals who have worked outside the UK to be completely exempt from income tax). This is regarded as an anachronism in a global marketplace which can no longer be justified.

To summarise, the following rules will apply from April 2018:

• all PILONs will be subject to tax and NICs as earnings
• all other post-employment payments which would have been treated as general earnings if the employee had worked their notice period will be subject to tax and Class 1, and
• payments relating directly to the termination of the employment will have a £30,000 income tax and employer NICs exemption. There will be continue to be an unlimited employee NICs exemption on termination payments.

Comment

The further consultation on the detailed implementation of the reforms is open until 05 October 2016 and responses should be sent to employmentincome.policy@hmrc.gsi.gov.uk