What are the taxing issues when employees receive termination payments?
When the employment relationship ends, employers may make severance payments for a number of reasons including payments in lieu of notice ("PILONs") to bring the employment relationship to an end immediately or ex gratia payments to encourage the person to sign a settlement agreement.
New rules on the taxation of employee termination payments came into force for terminations on or after 6 April 2018. HMRC's stated aim for this new regime was to address the anomaly that previously existed whereby contractual and "automatic" PILONs were taxable as income but PILONs genuinely made in breach of contract could benefit from the more favourable tax regime available for termination payments which allows the first £30,000 to be paid free of deductions for income tax and national insurance contributions.
The rules (found in sections 402A to 402E of the Income Tax (Earnings and Pensions) Act 2003) were intended to simplify the taxation of termination payments. However, almost four months into the new regime it is very clear that there is almost nothing simple about them.
The rules work by creating the concept of "post-employment notice pay" ("PENP") which must be calculated according to a formula set out in the rules. PENP is, in essence, the portion of any payment or benefit received directly or indirectly in connection with the termination of the employment which is referable to an unserved period of notice. PENP is taxable in full as earnings. Despite HMRC issuing guidance on the new rules, there remain many areas of uncertainty in terms of how the formula for calculating PENP works, and a number of situations in which the PENP rules lead to a surprising result.
This briefing highlights some of the tricky features of the new PENP regime, emphasising why employers calculating tax on termination payments should not assume that it is simply "business as usual".
Top five issues for employers
| 1. When do employers need to apply the new rules? |
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| The new rules do not replace existing rules on the taxation of PILONs - instead they require another layer of analysis and calculation. Contractual PILONs are still taxable in full as earnings, but employers must now also consider whether an even greater portion of any settlement payment is taxable in full as earnings. The PENP rules apply in any circumstance where an employee is receiving a payment in connection with the termination of their employment, unless the payment is either fully taxable as earnings under a different part of the relevant legislation or is a statutory redundancy payment. In our experience, the PENP rules are almost always engaged in a contentious termination situation, and also often in an amicable termination unless an employee is working their notice. However, it is not necessarily immediately apparent that the new rules will apply, and we are finding that it is easy for employers to overlook the need to do the PENP calculation. HMRC guidance on the new rules confirms that the PENP calculation needs to be done even if a contractual PILON is paid. |
| 2. Simple mathematics, tricky questions |
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| The formula requires an employer to multiply an employee's "basic pay" by the number of days in their notice period, then divide that by their pay period, and then subtract from that answer any amount paid on termination which is already taxable (including any contractual PILON). The formula can be simplified slightly if an employee is paid monthly, is entitled to contractual notice expressed in months and has an unserved period of notice of whole month(s). Once an employer has worked out the amount of PENP, this must then be compared with the termination payment to work out how much more, if any, of the termination payment is taxable. Whilst the calculation itself is not complicated mathematics, it is important for employers to be aware of the nuances of each component of the formula and to ensure that HR and payroll work closely together to ensure that details of pay and notice are correct. |
| 3. (Not so) basic pay |
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| The PENP formula uses the employee’s basic pay in respect of the last pay period of the employment ending before the trigger date. Basic pay means the total employment income the employee receives, or has the right to receive (even if they give up that right). This means that employers must include amounts which are salary sacrificed by an employee in the calculation of basic pay. If an employer calculates a contractual PILON based on a the employee's post-sacrifice salary, their PENP will be larger than the contractual PILON, and in our experience salary sacrificed amounts are often missed by employers when they consider the PENP calculation. Another potential trip wire is that the rules disregard allowances for the purpose of calculating basic pay, except if the allowance is really an amount which has been consolidated into standard pay. This leaves considerable room for debate on whether certain types of flat rate allowance which are often paid via payroll on the same data as salary, such as a car allowance or cash allowance in lieu of pension contributions, should be counted as basic pay or not. Unless and until HMRC issues further guidance, there will continue to be uncertainty about what should and should not be included. |
| 4. Make sure you take notice of the notice period |
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| The PENP formula multiplies basic pay by the number of days in the unserved period of notice. For this purpose, "notice" means the amount of notice required under contract or statute (whichever is longer) to be given by the employer to terminate the contract with notice. This is the case even if, in fact, notice was given by the employee and the employee is permitted to give a shorter period of notice than the employer. It also seems to be the case, although this has yet to be confirmed, that the PENP calculation must be carried out even if an employee is dismissed for gross misconduct, or if they object to a TUPE transfer – both situations in which the law does not require notice to be given. This has the potential to render more of a termination payment taxable than would have been the case for income if the employee had worked their notice period. It can also lead to confusion and risk where an employer is managing both a without prejudice process and an open process. |
| 5. Watch out for the anti-avoidance provisions |
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| The PENP rules contain general and specific anti-avoidance provisions which prevent employers and employees from taking steps to reduce the amount of tax that would otherwise be payable under the PENP rules. These provisions mean that an agreement between an employer and an employee (such as a term of a settlement agreement) to shorten an employee's notice period will not be effective to avoid PENP, and could also expose the employer to penalties. The potential scope and breadth of these anti-avoidance provisions means that employers need to be careful about what they promise to employees during negotiations, and careful to apply the PENP formula – with all its nuances – properly. |
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