UK: Tax On Termination Payments: The New Law In Practice

In April 2018, the new regime relating to the tax treatment of certain payments made on termination of employment (in particular, payments in lieu of notice (PILONs)) came into effect. Although the new rules were introduced as part of a tax simplification drive, they have nonetheless given rise to several areas of uncertainty.

Background

In broad terms, the intention of the new law was to ensure that all PILONs (whether such provisions are contractual or not) are taxable earnings and subject to income tax, PAYE and NICs. Under the new regime, 'relevant termination awards' are effectively split between:

  • amounts to be treated as taxable 'post-employment notice pay' (PENP); and
  • amounts which can benefit from the usual £30,000 tax exemption for certain termination payments.

Relevant termination awards do not include payments and benefits which are chargeable to tax by other provisions in the ITEPA 2003 outside of Chapter 3; therefore, for example, contractual PILONs continue to be fully taxable as general earnings under ITEPA 2003 s 62. The formula for calculating the PENP differs depending, amongst other things, on whether the employee is paid monthly or not, but for a monthly-paid employee the simplified calculation is as follows:

PENP = BP x D – T

where:

BP is the basic pay for the last pay period to end before the trigger date;

D is the number of months in the 'post-employment notice period'; and

T is any payment or benefit received in connection with the termination of the person's employment which is chargeable to tax as earnings (e.g. a contractual PILON).

So, for example, for an employee on a salary of £30,000 who is paid monthly and has a three month notice period (with no contractual PILON) the calculation would be:

PENP = BP (i.e. £2,500) x D (3) – T (i.e. nil) = £7,500

Can the parties agree a shorter notice period?

The amount which is subject to the PENP calculation is determined by reference to the 'minimum notice' required to be given by the employer to terminate the employee's employment by notice. This is effectively the greater of the notice period required by statute (i.e. the Employment Rights Act 1996) or the employment contract. If, for example, an employee had a relatively long notice period (e.g. 12 months), would it be possible for the parties to agree on or shortly prior to termination that this was reduced to a notice period that was shorter but still above the statutory minimum (e.g. three months) and thereby reduce the amount subject to the PENP calculation? This would seem unlikely in practice.

To begin with, ITEPA 2003 s 402D(11) is effectively an anti-avoidance rule applying where the purpose of certain arrangements is to cause the PENP to be less than it would otherwise have been. Unless the change had been made for reasons unconnected with the termination (and preferably some time before termination), there is a real risk that the changes would be caught by those anti-avoidance provisions. In addition, there is also a risk that a payment made to an employee in consideration of the employee agreeing to changes to the employment terms would be caught as earnings referable to employment and therefore classified as general earnings within the scope of s 62.

Taxation on summary or constructive dismissals?

What is the tax position if an employee is dismissed summarily with no notice (e.g. for gross misconduct) or resigns claiming constructive dismissal and brings a claim against the employer for damages in respect of the notice period which is then settled? Or what if an employee resigns without giving notice and subsequently a settlement is reached under which the employee is paid a termination payment? How is the settlement payment in such cases treated?

At least on the face of the legislation, it would appear that the employer must apply the usual PENP calculation. Section 402D requires the employer to assess the length of the 'post-employment notice period' for the purposes of the PENP calculation. The post-employment notice period commences on the last day of employment and ends on the 'earliest lawful termination date', which is itself defined by reference to the minimum notice that must be given by the employer to terminate the employee's employment by notice in accordance with the relevant law and contractual terms. This would suggest that, even in relation to settlement payments made in situations of gross misconduct, constructive dismissal or resignation without notice, the employer must carry out a PENP calculation in respect of any settlement payment.

We understand that, in practice, HMRC has informally advised that if an employee is summarily dismissed the PENP would be nil. If, however, it was subsequently established by a tribunal that the employee was entitled to a notice period (in respect of which no payment had been made), then any settlement amount should have the PENP calculation applied to it.

Employee's shorter notice period

It is odd that, under the legislation, the calculation of the PENP is based solely on the employer's notice period. This is because ITEPA 2003 s 402E(4) (the provision which determines the minimum notice period for the purposes of calculating the PENP) specifically refers to the 'minimum notice to be given by the employer' (our emphasis). It would seem that this is a deliberate choice by those drafting the legislation, not least because other provisions of s 402 do refer to notice which has been given by either the employer or the employee (e.g. s 402E(3)). This in practice leaves an odd position when the period of notice which an employee is required contractually to give is shorter than the notice required by the employer (or even perhaps a situation in which an employee is served with notice of termination by the employer for redundancy and the employee serves a counter-notice of termination, bringing the employment to an end at an earlier date (Employment Rights Act 1996 s 136(3)).

If the employee gives notice, but still receives a termination payment, the PENP will have to be calculated but based on the longer period of notice that would have applied to an employer notice, potentially meaning that part of the termination payment may then fall within the PENP and be fully taxable. This may leave the employee in a position where he/she is expecting to receive a payment which in practice is not labelled as a PILON but which nonetheless gets taxed under the PENP provisions.

One of the key purposes of the new PENP provisions was to give more certainty to employers about the tax treatment of PILONs. A basic concept of the new legislation was that, if notice was worked by the employee, the PENP would essentially be nil. However, the outcome of the PENP still applying to a termination payment where the employee's worked notice period is shorter than the employer's notice period arguably shows that the intention has not been entirely met by the legislation in practice.

Basic pay: low/no pay or unusually high amounts of pay

The concept of 'basic pay' feeds into the calculation of the PENP. In broad terms, this covers the employment income that the employee received in the 'last pay period' prior to the relevant trigger date (the legislation deems certain items not to be included as employment income for these purposes). However, what if the employee had been off sick prior to termination and was receiving either statutory sick pay (SSP), or indeed had exhausted SSP and was not receiving any pay at all? Is the PENP then calculated on the basis of that reduced or nil pay?

The legislation does not define what is meant by a 'last pay period' but examples given in its guidance (see HMRC's Employment Income Manual at EIM13888) strongly suggest that HMRC takes the view that this means the standard payroll period operated by the employer for that employee. If the employee was receiving SSP during that period, it might be argued that this should not be counted as employment income for the purposes of the PENP calculation, as arguably SSP would not fall within the definition of employment income set out at ITEPA 2003 s 7(2). However, HMRC's guidance at EIM76350 may indicate that it does not share this view:

'SSP is payable by the employer. SSP is not a social security benefit funded by the state. It is a mandatory provision under social security law. Broadly SSP is a measure of earnings replacement paid by employers to employees whilst they are unable to work through illness administered and mainly funded by employers. Section 151 of the Social Security Contributions and Benefits Act 1992 requires the employer to make the payments. This means that payments of SSP are charged to tax as employment income.'

This would suggest that if the employee is receiving SSP in the period prior to termination, that is counted as the employment income for the purposes of determining basic pay for PENP purposes; however, this remains uncertain.

The reality is that the complexity of the detail of the PENP regime has introduced a number of areas of new uncertainty

If the employee was receiving no pay at all prior to termination (e.g. because his/her entitlement to SSP (28 weeks) had been exhausted and there was no company-related sick pay scheme in place), there is even greater uncertainty as to whether 'basic pay' for that employee would effectively be nil (because nothing was paid in the relevant pay period) or whether the 'pay period' should, for such an employee, effectively be interpreted as meaning the last pay period during which some employment income was paid.

Basic pay and allowances

As noted above, s 402D(7) sets out what is meant by basic pay, but deems certain items to be disregarded for those purposes. Section 402D(7)(a)(i) provides that 'any amount received by way of overtime, bonus, commission, gratuity or allowance' shall be disregarded. ITEPA 2003 does not define what is meant by 'allowances'. HMRC has given its own guidance on what is meant by this term (EIM13884), which states:

'The term allowance is wide in scope. An allowance is an amount received by an employee as a supplementary payment over and above their standard pay. The period over which the allowance is paid, or the activity to which the allowance relates may, or may not be temporary in nature. Allowances could be paid:

  • in recognition of particular circumstances, such as an additional responsibility allowance for temporarily undertaking duties not otherwise required under the employment contract;
  • in recognition of particular working arrangements, such as weekend working allowance for an employee working unsociable hours; and
  • to reimburse an employee for out of pocket expenses, such as a travel allowance to cover an employee's transport costs whilst performing duties of the employment.

'There are a variety of reasons why allowances are paid. The above list is not exhaustive.

'An allowance does not include any amount which is actually, or in reality reflects an amount that has been consolidated into an employee's standard pay.'

Although the above guidance gives some clarity on what is included within the scope of allowances, it still leaves a lot of room for uncertainty. For example, one common type of allowance is a car allowance (often provided as an alternative to a company car). Some practitioners have taken the view that such allowances would fall within the definition of 'allowances' in s 402D(7)(i) if they are not guaranteed (e.g. if they are simply paid by reference to actual business miles incurred each month), whereas car allowances which are fixed guaranteed amounts paid to the employee each month in lieu of having a company car may effectively be 'consolidated into the employee's pay' and therefore fall outside the definition.

HMRC has indicated informally that if an employee is offered a choice between a company car and a car allowance, then such a car allowance might be an allowance for the purposes of s 402D(7)(i), whereas an allowance which was provided with no alternative, or as part of a salary sacrifice arrangement with no option to have a company car, might be an arrangement that did not count as an allowance for those purposes (although HMRC noted that each case would be very fact specific).

Action points

On one level, the new legislation has achieved its aim of simplification. At a very high level, it is probably true to say that HR and payroll practitioners can say with more certainty that there is no longer a need to distinguish between contractual and non-contractual PILONs, as both types of PILON will now in principle be subject to income tax.

In that sense, the new legislation has created more certainty and simplified the regime. Nonetheless, the reality is that the complexity of the detail of the PENP regime has introduced a number of areas of new uncertainty, some of which have been explored above. Employers faced with such issues should consider:

  • seeking bespoke tax advice on the relevant issue before committing to a particular course of action;
  • seeking guidance or advance clearance from HMRC on the specific issue, if the circumstances of the termination allow for it; and/or
  • if acting for the employer, including within the settlement agreement (if one is used) a comprehensive indemnity from the employee in respect of any additional income tax or (employee's) NICs that may be deemed due on the payments or benefits provided under the agreement.

Previously published in Tax Journal on November 9 entitled "Tax on Termination Payments: The New Law in Practice."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
Shepherd and Wedderburn LLP
Brahams Dutt Badrick French LLP
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Shepherd and Wedderburn LLP
Brahams Dutt Badrick French LLP
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions