To many HR professionals, and even employment lawyers, tax is not the most enthralling of topics. But sometimes a change comes along which we just need to know about. On this occasion, it relates to a new tax treatment of payments in lieu of notice (PILONs), which comes into effect on 6 April 2018.
It is not particularly surprising that HM Revenue & Customs (HMRC) has decided to change the rules on the tax treatment of PILONs: the current position is unsatisfactory on both sides. At the moment the position is this:
- If a contract provides that an employer can terminate an employee's employment immediately and make a PILON instead of requiring an employee to work their notice, that payment is fully taxable as if were salary.
- If there is no contractual right to make a PILON, but the employer has an "automatic" or "customary" practice of paying in lieu of notice in response to a termination (known as an "auto-PILON"), HMRC's view is that the payment is taxable as general earnings. As you can imagine, what amounts to an automatic payment is often the subject of debate.
- If there is no PILON in a contract (and it is not an "auto-PILON"), substituting the notice period with a payment is technically a breach of contract. This currently means that the payment is treated as damages (ie compensation in recognition of an employer's failure to serve proper notice) and forms part of a termination payment, the first £30,000 of which can be paid tax free.
HMRC's gripe is that employers are often able to structure termination payments as damages to reduce the tax payable, which is why we find ourselves now facing new rules...
What is changing?
The long and the short of it is that from 6 April 2018 all PILONs (whether contractual or not) will be taxed as general earnings and so subject to income tax and national insurance contributions. In other words, the £30,000 exemption will not be available for any payments in lieu of notice.
This is being achieved through the introduction of a new concept called "post-employment notice pay" (PENP), which effectively taxes as earnings the basic pay which the employee would have earned had the employee worked his or her notice and therefore replaces non-contractual PILONs. There is a statutory formula for calculating PENP, which is cumbersome to say the least. I will not try your patience by reproducing it here, but if you find yourself needing to calculate PENP, I recommend seeking specialist advice and alerting your payroll.
A few important points to note:
- PENP is based on the employee's basic pay which does not include overtime, bonuses, certain allowances and benefits.
- In some situations, enhanced contractual redundancy payments may fall within the PENP calculation and so when making an enhanced contractual redundancy payment for an employee who has not served their full notice, the new rules should be considered. Statutory redundancy payments on other hand are excluded and will continue to be eligible for the £30,000 exemption.
- Despite initial reports suggesting otherwise, the change to PILONs only applies to situations where both the payment and the termination of employment occur on or after 6 April 2018.
- The legislation contains anti-avoidance provisions which mean that it is not possible to agree a shorter notice period with an employee after the fact (so as to reduce the tax).
- The statutory formula for calculating PENPs may not fit easily into all employers' payroll systems. If you need to calculate PENP, we suggest you speak with your payroll adviser to ensure that your system can be adjusted to make the calculation.
- The £30,000 exemption remains available for other termination payments, such as compensation for loss of office.
What should employers be doing?
If your contracts of employment have a PILON clause and you currently tax any such payments as general earnings, these changes should not have any impact on you.
If your contracts do not include a PILON, any tax advantage of not having one will fall away in April. As a result, it seems to us that there is little benefit in not including a contractual PILON clause in your contracts, and indeed several disadvantages in not doing so. These include the potential impact on restrictive covenants (since making a PILON in breach of contract renders restrictive covenants unenforceable) and the need to get entangled in the complicated statutory formula. For these reasons, our advice is that employers should consider including a PILON clause in their employment contracts as standard.
If you are currently negotiating a settlement agreement with an employee where these changes may make a difference to the tax treatment of a payment, it is obviously worth trying to agree a termination date of before 6 April (even if the payment is made after that). It would also be possible to agree to make the termination payment in advance of 6 April, although this may not be a particularly desirable option unless an employee's employment is due to terminate shortly afterwards. For terminations and payments after 6 April, consider expressly stating the tax position of PILONs / PENPs in a settlement agreement, so everyone is clear.
In other tax and related news
Whilst I am on the topic of tax, I thought it worth mentioning some other related points:
- As of 6 April, Foreign Service Relief will no longer be available on termination payments where the employee is a UK tax resident in the year their employment terminates. It is irrelevant how long they have worked abroad prior to that.
- As we reported after the Autumn budget (here), all termination payments above the £30,000 threshold will be subject to class 1A NICs (employer liability only) from 6 April 2019, rather than this year as originally announced.
- Payments for injury to feelings will fall outside the tax exemption for injury payments except where the injury amounts to a psychiatric injury or other recognised medical condition.
- Employment tribunal compensation limits will increase on 6 April 2018, the main ones being:
- a. Maximum week's pay (for redundancy payments and unfair dismissal basic award): £508 (up from £489).
- b. Maximum compensatory award for unfair dismissal: £83,682 (up from £80,581).
- The National Minimum Wage rates will increase on 1 April 2018; over 25s will be entitled to £7.38 (up from £7.50).
With thanks to Charlotte Black and James Bromley in our Tax Team for their input into this blog. We and they would be happy to help further if you have got any questions.
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