Last Summer the Government consulted on proposed changes to the tax treatment of termination related payments. This included proposed changes in relation to non-contractual payments in lieu of notice (“PILONs”), the £30,000 tax exemption on certain termination payments, and the tax treatment of legal fees which are often paid when a departing employee signs a settlement agreement. Some of the proposals were quite substantial, and we felt would make the law more complicated than it already is, so we responded to the consultation and argued on our clients’ behalf for a simpler approach to taxing termination payments.
The Government has now published its response to the consultation as well as draft legislation which is expected to come into force in April 2018, and there is mixed news for employers.
The good news is that:
- the £30k tax exemption will remain (although we had argued that it should be increased, since it has remained at the same level since 1988); and
- the tax treatment of legal fees paid under a settlement agreement will remain as it is now.
However, in future:
- all PILONs will be subject to deductions for income tax and National Insurance contributions;
- employers National Insurance contributions (but not employee NI) will be payable on any part of a compensation payment that is taxable; and
- foreign service relief will be abolished.
PILONs – Currently, an employer may pay up to £30,000 of notice monies free of tax where there is no contractual PILON. The payment is treated as damages for breach of contract. However, HMRC can challenge whether or not the first £30k of the PILON is tax free and it might argue that an “auto-PILON” is implied into the employment contract and then treat the payment as taxable. The risk of HMRC deciding that there is an “auto-PILON” increases where an employer habitually makes tax-free PILONs rather than requiring employees to work out their notice or placing them on garden leave. By making all PILONs taxable (whether or not they are contractual) simplifies matters, but it will disadvantage those employers – and their employees – who seek to use damages payments for breach of contract as a way of paying termination payments free of tax.
Employer NICs – The current position is that no National Insurance contributions are paid on termination payments where £30k has been paid free of tax. This can amount to a significant cost saving, particularly for employers. The Government has decided that employers, but not employees, will have to start making National Insurance contributions. Employers who propose to make substantial termination payments in the first half of 2018 will need to plan carefully when those payments are made in order to try and beat the date on which employer National Insurance contributions will become payable.
Foreign service relief – In very broad terms, employers who have worked abroad for a period of time can qualify for full or partial relief from tax on their termination payments. However, this relief will be abolished.
What steps should HR be taking now?
- Those employers whose employment contracts do not contain PILON clauses should consider revising them and inserting contractual PILONs. Paying notice monies in damages will cease to be tax efficient and means that the employee ceases to be bound by ongoing contractual obligations such as post-termination restrictive covenants. Further, a contractual PILON can be limited to basic salary only, whereas a damages payment will include loss of benefits (including pension contributions, bonus payments, and the cost to the employee of replacing insurances such as private medical insurance) – thereby saving the employer money.
- Consider very carefully when termination payments will be made in 2018. Employers may start to negotiate with employees early next year in relation to termination payments due in 2018, and the cost to the employer could be significantly higher if the payment is made once the new laws come in and employers NICs is due.