Termination payments: What do new taxation rules mean for UK employers?

The UK government embarked last year on a series of reforms to how tax and National Insurance Contributions (NICs) were treated in relation to staff termination payments. Most of the changes, which are significant and the first in 30 years, are due to come into effect in April this year, but further updates are also planned for April 2019.

Of what do the changes consist?

From 6 April 2018, the new legislation will:

• Effectively treat all payments in lieu of notice as earnings that are subject to tax and class 1 NICs;
• Ensure that payments for injury to feelings fall outside of the exemption for injury payments, except where it amounts to a psychiatric injury or any other recognised medical condition;
• Abolish foreign-service relief, except in relation to seafarers, for UK resident employees;
• Permit Her Majesty’s Treasury to vary the £30,000 (US$41,421) threshold by regulation.

As of 6 April 2019, the legislation will:

• Subject all termination payments above the £30,000 threshold to class 1A NICs (employer liability only).

How have the changes been enacted?

• The abolition of foreign service relief for UK resident employees has been introduced in clause 10 of the Finance Bill 2018;
• Section 5 of the Finance (No.2) Act 2017 implements the other taxation elements;
• Subjecting termination payments above £30,000 to class 1A NICs will be implemented in a ‘National Insurance Contributions Bill’, which will be published later in 2018. Secondary legislation to deal with the collection mechanism, which is expected to be a real-time one, is likewise expected in 2018.

What is covered under payments in lieu of earnings?

Over the years, tax/NIC treatment has often been inconsistent for payments in lieu of notice (PILON). If there is no mention of it in an employment contract or any discretion in how to deal with it, PILON has generally been treated as a ‘damages payment’ for breach of contract. As such, it was deemed to qualify for the £30,000 tax exemption and full exemption from NICs.

But the new rules will change this situation. Instead employers will be required to split a termination award between amounts that are treated as earnings (new section 402B, ITEPA 2003) and amounts that benefit from the £30,000 exemption (section 403, ITEPA 2003).

The legislation works by first identifying any payments that should be treated as earnings. Any remainder is then subject to the £30,000 exemption. Statutory redundancy payments are exempt from income tax and NICs and automatically benefit from the £30,000 exemption.

But compensation for unfair dismissal will need to be treated as earnings, subject to tax under the legislation, in the case of:

• The entire termination award, disregarding redundancy and approved contractual pay, if ‘post-employment notice pay’ is equal to or more than the termination payment;
• Post-employment notice pay, if post-employment notice pay is less (but not nil) than the termination award.

Broadly speaking, the intention is to tax as earnings, the basic pay an employee would have earned had they worked their notice. It is worth bearing in mind that anti-avoidance provisions have also been included in the legislation.

As an employer, how can I calculate this?

Although slightly complicated, the way to work it out is using the formula ‘(BP x D/P) minus T’, where:

• BP = Work out Basic Pay for the last pay period to end before the trigger date (the day notice is given or, if notice is not given, the last day of employment);
• D = Length of the post-employment notice period in Days;
• P = The number of days in the pay Period used to calculate basic pay;
• T = The Total, which is the amount of any payment or benefit received in connection with the termination, which is:

1. Already subject to tax under another section of the taxation legislation;
2. Not paid in respect of holiday entitlement for a period before employment ends;
3. Not a bonus payable for termination of employment.

Things are slightly simpler if the employee was paid on a monthly basis as their notice period and ‘post-employment notice period’ are both expressed in months. The post-employment notice period begins at the end of the last day of employment and ends with the earliest lawful termination date. There are also some additional provisions covering fixed-term contracts with no contractual notice provision.

How is basic pay defined?

Basic pay is employment income disregarding overtime, bonuses, commissions, gratuities, allowances, termination awards, benefits in kind and amounts treated as earnings such as share-based earnings. But it also includes sums that would have been received for everything but salary sacrifice arrangements.

To provide an example, ‘Fred’ receives £6,000 (US$8,284) each month in basic pay and is subject to a three-month notice period. His employer makes a termination payment of £30,000 and Fred’s contract does not include a contractual PILON.

There is one month in the last pay period. Applying the formula laid out above (£6,000 x 3/1), Fred’s post-employment notice pay would be £18,000 (US$24,853). Because the figure is less than his termination payment, only that amount is treated as earnings, subject to tax and NICs. The remaining amount (£12,000 or US$16,568) would be considered under regular termination payment tax rules.

What about foreign-service relief?

Foreign-service relief has long provided for the possibility of exemptions from UK income tax for employees who work a substantial part of their overall time overseas. The relief exempts the portion of a termination payment relating to foreign service from UK income tax. In certain situations, this relief has provided full exemption from UK income tax for qualifying payments.

But the new legislation means that employees who are UK tax-resident in the UK tax year in which their employment is terminated, are no long eligible for the relief. As a result, termination payments subject to the available £30,000 exemption will be subject to UK income tax.

The relief will continue for those who are not UK tax-resident in the UK tax year in which the employment is terminated. Exemptions will also apply for UK resident employees with foreign seafaring service.

This means that the changes will have a significant impact on staff members who have a substantial overseas service component to their employment history. The loss of foreign-service relief may result in impacted employees paying higher levels of UK income tax, while employers will be obliged to withhold tax under Pay As You Earn (PAYE). 

International complications

In an international context, income tax may be due in other countries on the same termination payment. Going forward, it will be necessary for impacted employees to understand how these foreign taxes interact with the UK income tax they owe.

In theory, a foreign tax credit may be available. But if there are timing differences between the UK PAYE deduction, the payment of foreign income tax and a foreign tax credit claim (usually the employee’s personal income tax return), it may lead to real double taxation, at least in the short-term.

If employers have an income tax withholding and reporting obligation in two or more jurisdictions the question is how will this work in practice, which is as yet unclear.

There are similar questions over UK tax residency. For example, the UK tax residency of an employee may not be clear until the tax year has ended. But if their termination payment has already been made mid-way through the tax year, on what PAYE basis will their employer make deductions?

What changes are there to ‘injury to feelings’ legislation?

Under existing legislation, if a payment is made to an employee due to injury or disability, there is the possibility they will be completely exempted from having to pay tax on it. The tests for this exemption can be found by referring to the case of ‘Horner v Hasted (Inspector of Taxes) [1995] STC 766’. 

But other recent cases have meant the government felt it necessary to clarify that, from 6 April 2018 onwards, injury to feelings payments are not included, although psychiatric injury payments are.

What about the £30,000 exemption?

The exemption limit has not changed. But there is an anomaly between the tax and NIC rules, in that termination payments that are not ‘earnings’ are exempt without limit from NICs for both employers and employees.

Originally, the government had sought to change this situation at the same time as it introduced change to its other legislation. But the move has now been postponed until April 2019 when a £30,000 cap will be introduced for employer NICs only, by way of class 1A.

What are the implications of these changes?

Because these shifts are far-reaching, employers, employees and lawyers will all need to adjust their thinking to ensure termination payments receive the right treatment. Doing so will take time given the existing rules have not altered for many years.

For those dealing with terminations in the run up to April 2018, timings could make a difference. The same is true in the run up to April 2019 when a new employers’ NIC charge will be introduced.

But it is also not completely clear what happens to payments received during fiscal year 2018/19 if a termination occurred in 2017/18. Her Majesty’s Revenue & Customs (HMRC) has now confirmed its view that the new rules will only apply to payments made on or after 6 April 2018 if employment ended on or after 6 April 2018.

This means that payments made in 2018/19 following a termination that took place in 2017/18 will remain subject to the “old” rules. Therefore, non-contractual PILONs may be subject to the £30,000 exemption in full if such payments form part of a termination settlement. However, clarification is expected to be included in guidance to be published shortly by HMRC.

As a result, even though the government’s aim in updating the legislation was to clarify existing rules, it is not going to prove as straightforward as that immediately. Thus, if employers are uncertain of their obligations, they would be advised to seek specialist advice to ensure they remain compliant.

Susan Ball is partner at Crowe Clark Whitehill LLP and heads up its Employers Advisory Group. She has more than 30 years’ experience focusing on UK and overseas employment tax, social security, investigations and rewards.  Susan also sits on the Council of the Chartered Institute of Taxation (CIOT) as well as on its Employment Taxes sub-committee.

Dinesh Jangra is a partner at Crowe Clark Whitehill and heads up its Mobility Services business. He has more than 18 years of experience in advising employers and employees on tax, payroll and social security issues related to cross-border working, international assignments and relocations. Dinesh is an expert in cross-border tax considerations relating to compensation, tax and social security planning for expatriates and in enabling cost-effective and compliant global mobility.

The UK government embarked last year on a series of reforms to how tax and National Insurance Contributions (NICs) were treated in relation to staff termination payments. Most of the changes, which are significant and the first in 30 years, are due to come into effect in April this year, but further updates are also planned for April 2019.

Of what do the changes consist?

From 6 April 2018, the new legislation will:

• Effectively treat all payments in lieu of notice as earnings that are subject to tax and class 1 NICs;
• Ensure that payments for injury to feelings fall outside of the exemption for injury payments, except where it amounts to a psychiatric injury or any other recognised medical condition;
• Abolish foreign-service relief, except in relation to seafarers, for UK resident employees;
• Permit Her Majesty’s Treasury to vary the £30,000 (US$41,421) threshold by regulation.

As of 6 April 2019, the legislation will:

• Subject all termination payments above the £30,000 threshold to class 1A NICs (employer liability only).

How have the changes been enacted?

• The abolition of foreign service relief for UK resident employees has been introduced in clause 10 of the Finance Bill 2018;
• Section 5 of the Finance (No.2) Act 2017 implements the other taxation elements;
• Subjecting termination payments above £30,000 to class 1A NICs will be implemented in a ‘National Insurance Contributions Bill’, which will be published later in 2018. Secondary legislation to deal with the collection mechanism, which is expected to be a real-time one, is likewise expected in 2018.

What is covered under payments in lieu of earnings?

Over the years, tax/NIC treatment has often been inconsistent for payments in lieu of notice (PILON). If there is no mention of it in an employment contract or any discretion in how to deal with it, PILON has generally been treated as a ‘damages payment’ for breach of contract. As such, it was deemed to qualify for the £30,000 tax exemption and full exemption from NICs.

But the new rules will change this situation. Instead employers will be required to split a termination award between amounts that are treated as earnings (new section 402B, ITEPA 2003) and amounts that benefit from the £30,000 exemption (section 403, ITEPA 2003).

The legislation works by first identifying any payments that should be treated as earnings. Any remainder is then subject to the £30,000 exemption. Statutory redundancy payments are exempt from income tax and NICs and automatically benefit from the £30,000 exemption.

But compensation for unfair dismissal will need to be treated as earnings, subject to tax under the legislation, in the case of:

• The entire termination award, disregarding redundancy and approved contractual pay, if ‘post-employment notice pay’ is equal to or more than the termination payment;
• Post-employment notice pay, if post-employment notice pay is less (but not nil) than the termination award.

Broadly speaking, the intention is to tax as earnings, the basic pay an employee would have earned had they worked their notice. It is worth bearing in mind that anti-avoidance provisions have also been included in the legislation.

As an employer, how can I calculate this?

Although slightly complicated, the way to work it out is using the formula ‘(BP x D/P) minus T’, where:

• BP = Work out Basic Pay for the last pay period to end before the trigger date (the day notice is given or, if notice is not given, the last day of employment);
• D = Length of the post-employment notice period in Days;
• P = The number of days in the pay Period used to calculate basic pay;
• T = The Total, which is the amount of any payment or benefit received in connection with the termination, which is:

1. Already subject to tax under another section of the taxation legislation;
2. Not paid in respect of holiday entitlement for a period before employment ends;
3. Not a bonus payable for termination of employment.

Things are slightly simpler if the employee was paid on a monthly basis as their notice period and ‘post-employment notice period’ are both expressed in months. The post-employment notice period begins at the end of the last day of employment and ends with the earliest lawful termination date. There are also some additional provisions covering fixed-term contracts with no contractual notice provision.

How is basic pay defined?

Basic pay is employment income disregarding overtime, bonuses, commissions, gratuities, allowances, termination awards, benefits in kind and amounts treated as earnings such as share-based earnings. But it also includes sums that would have been received for everything but salary sacrifice arrangements.

To provide an example, ‘Fred’ receives £6,000 (US$8,284) each month in basic pay and is subject to a three-month notice period. His employer makes a termination payment of £30,000 and Fred’s contract does not include a contractual PILON.

There is one month in the last pay period. Applying the formula laid out above (£6,000 x 3/1), Fred’s post-employment notice pay would be £18,000 (US$24,853). Because the figure is less than his termination payment, only that amount is treated as earnings, subject to tax and NICs. The remaining amount (£12,000 or US$16,568) would be considered under regular termination payment tax rules.

What about foreign-service relief?

Foreign-service relief has long provided for the possibility of exemptions from UK income tax for employees who work a substantial part of their overall time overseas. The relief exempts the portion of a termination payment relating to foreign service from UK income tax. In certain situations, this relief has provided full exemption from UK income tax for qualifying payments.

But the new legislation means that employees who are UK tax-resident in the UK tax year in which their employment is terminated, are no long eligible for the relief. As a result, termination payments subject to the available £30,000 exemption will be subject to UK income tax.

The relief will continue for those who are not UK tax-resident in the UK tax year in which the employment is terminated. Exemptions will also apply for UK resident employees with foreign seafaring service.

This means that the changes will have a significant impact on staff members who have a substantial overseas service component to their employment history. The loss of foreign-service relief may result in impacted employees paying higher levels of UK income tax, while employers will be obliged to withhold tax under Pay As You Earn (PAYE). 

International complications

In an international context, income tax may be due in other countries on the same termination payment. Going forward, it will be necessary for impacted employees to understand how these foreign taxes interact with the UK income tax they owe.

In theory, a foreign tax credit may be available. But if there are timing differences between the UK PAYE deduction, the payment of foreign income tax and a foreign tax credit claim (usually the employee’s personal income tax return), it may lead to real double taxation, at least in the short-term.

If employers have an income tax withholding and reporting obligation in two or more jurisdictions the question is how will this work in practice, which is as yet unclear.

There are similar questions over UK tax residency. For example, the UK tax residency of an employee may not be clear until the tax year has ended. But if their termination payment has already been made mid-way through the tax year, on what PAYE basis will their employer make deductions?

What changes are there to ‘injury to feelings’ legislation?

Under existing legislation, if a payment is made to an employee due to injury or disability, there is the possibility they will be completely exempted from having to pay tax on it. The tests for this exemption can be found by referring to the case of ‘Horner v Hasted (Inspector of Taxes) [1995] STC 766’. 

But other recent cases have meant the government felt it necessary to clarify that, from 6 April 2018 onwards, injury to feelings payments are not included, although psychiatric injury payments are.

What about the £30,000 exemption?

The exemption limit has not changed. But there is an anomaly between the tax and NIC rules, in that termination payments that are not ‘earnings’ are exempt without limit from NICs for both employers and employees.

Originally, the government had sought to change this situation at the same time as it introduced change to its other legislation. But the move has now been postponed until April 2019 when a £30,000 cap will be introduced for employer NICs only, by way of class 1A.

What are the implications of these changes?

Because these shifts are far-reaching, employers, employees and lawyers will all need to adjust their thinking to ensure termination payments receive the right treatment. Doing so will take time given the existing rules have not altered for many years.

For those dealing with terminations in the run up to April 2018, timings could make a difference. The same is true in the run up to April 2019 when a new employers’ NIC charge will be introduced.

But it is also not completely clear what happens to payments received during fiscal year 2018/19 if a termination occurred in 2017/18. Her Majesty’s Revenue & Customs (HMRC) has now confirmed its view that the new rules will only apply to payments made on or after 6 April 2018 if employment ended on or after 6 April 2018.

This means that payments made in 2018/19 following a termination that took place in 2017/18 will remain subject to the “old” rules. Therefore, non-contractual PILONs may be subject to the £30,000 exemption in full if such payments form part of a termination settlement. However, clarification is expected to be included in guidance to be published shortly by HMRC.

As a result, even though the government’s aim in updating the legislation was to clarify existing rules, it is not going to prove as straightforward as that immediately. Thus, if employers are uncertain of their obligations, they would be advised to seek specialist advice to ensure they remain compliant.

Susan Ball is partner at Crowe Clark Whitehill LLP and heads up its Employers Advisory Group. She has more than 30 years’ experience focusing on UK and overseas employment tax, social security, investigations and rewards.  Susan also sits on the Council of the Chartered Institute of Taxation (CIOT) as well as on its Employment Taxes sub-committee.

Dinesh Jangra is a partner at Crowe Clark Whitehill and heads up its Mobility Services business. He has more than 18 years of experience in advising employers and employees on tax, payroll and social security issues related to cross-border working, international assignments and relocations. Dinesh is an expert in cross-border tax considerations relating to compensation, tax and social security planning for expatriates and in enabling cost-effective and compliant global mobility.