In July 2015, the government published a consultation on proposals to reform the tax treatment of termination payments, which was widely discussed with stakeholders. Nine months after the end of that consultation, the government has published a revised proposal, together with draft legislation. Stakeholders are invited to comment by 5 October 2016. It is intended that the new rules will be implemented with effect from April 2018.
The new proposal includes a number of positive aspects, including that the tax exemption will not be confined to termination payments made in a redundancy situation (as had been suggested previously), that the current level of the tax free threshold (£30,000) will be maintained (at least for the time being) and that most of the current reliefs applicable to termination payments will also be maintained.
However, it is also clear that the proposed changes will erode the concept of termination payments that can potentially benefit from the £30,000 exemption.
The main features of the revised proposal
The concept of termination payments is retained in that any payment made to an employee solely in relation to a termination of employment will continue to benefit from a tax free threshold of £30,000 and will continue to be free from employee's national insurance contributions (NICs). However, termination payments in excess of £30,000 will be subject to income tax (as previously) and also to employer's NICs (in contrast to the current position where termination payments are fully exempt from NICs).
While the distinction between contractual payments and non-contractual payments will be retained in principle, the draft legislation provides that any payment that the employee would have received if they had worked their contractual notice period will be subject to income tax and NICs – regardless of when the employee actually leaves or whether the employment contract restricts entitlement in a termination situation. Further, all payments in lieu of notice (PILONs), whether contractual or non-contractual, will be subject to income tax and NICs in full. The draft legislation achieves this by providing that the relevant payments will fall within a defined type of payment which is subject to income tax and NICs, and it is therefore irrelevant how any such payments are 'labelled' in a settlement agreement.
Statutory redundancy payments will continue to benefit from the £30,000 exemption.
Existing reliefs which exempt termination payments in excess of £30,000 from income tax will be largely maintained, with the following modifications:
- It will be clarified that the exemption for termination payments made in respect of death, disability or injury will not apply in cases of injured feelings.
- Foreign service relief will be abolished (other than for seafarers).
The draft legislation erodes the scope of the £30,000 exemption by cutting across the terms of the contract of employment, in particular with regard to bonus payments
The principles set out above make for an uneasy relationship between the legislative provisions and the terms set out in a contract of employment. Essentially, the draft legislation requires employers to consider what the employee would have been entitled to under his contract if he had worked his entire contractual notice period, but without having regard to the termination itself and any provisions restricting entitlement in the event of a termination.
This is best illustrated by worked examples:
Example 1 – PILONs: An employee is entitled to gross salary of £48,000 per year and a minimum of six months' notice. The contract does not provide for a PILON, and the employment is terminated without notice. On termination the employee receives a payment of £60,000.
Tax treatment under the proposed new rules: If the employee had worked during his contractual six months' notice period, he would have received salary of £24,000. Accordingly, £24,000 of the £60,000 termination payment will be subject to income tax and NICs. The remaining £36,000 will be taxed as a termination payment, i.e., the first £30,000 will be exempt from income tax and NICs, and the balance of £6,000 will be subject to income tax and employer's NICs (but not employee's NICs).
Comparison with current rules: Under current rules, it would be arguable that the entire payment should be a termination payment which would be subject to income tax only above the £30,000 exemption, and would be exempt from NICs, on the basis that there is no contractual PILON (assuming that the employer does not operate a custom or practice of making PILONs and that the employee does not have a reasonable expectation to receive a PILON).
Example 2 – bonus payments: An employee is entitled to gross salary of £48,000 per year and a minimum of six months' notice. The employee is also entitled to participate in a bonus scheme by reference to the employer company's results in the calendar year. Where a bonus is earned, it is paid on 30 April following the calendar year in respect of which the bonus was earned, and the contract further provides that the bonus is only payable if the employee is employed on the bonus payment date.
The employee is dismissed without notice on 30 September and receives a payment of £72,000 on termination. But for the dismissal, he would have been reasonably expected to receive a bonus of £12,000 based on the employer company's results in the calendar year during which the dismissal took place.
Tax treatment under the proposed new rules: As before, there will be a taxable PILON of £24,000. Also, a further £12,000 will be subject to income tax and NICs as earnings by reference to the bonus that the employee would have been expected to receive (despite the fact that he did not actually qualify for a bonus under the terms of the bonus scheme). The reasoning is that if the employee had worked his six months' notice period, this would have taken him beyond the end of the calendar year on which the bonus entitlement is based, and he would have received the bonus but for the dismissal, which prevented the employee from being employed on the bonus payment date (30 April). The remaining £36,000 will be taxed as a termination payment as set out in Example 1.
Comparison with current rules: Under current rules, it would be arguable that the £12,000 (which under the proposed new rules will be taxed as earnings subject to income tax and NICs by reference to the bonus) should instead be treated as forming part of the termination payment and therefore be exempt from NICs, on the basis that the employee has no contractual entitlement to receive the bonus (assuming that the employer does not operate a custom or practice of paying the bonus anyway and that the employee does not have a reasonable expectation to receive the bonus).
As is clear from the above examples, the revised rules will push more elements of a termination package into the category of 'contractual payments', which are earnings fully subject to income tax and NICs. In our view, this is far removed from the original stated purpose of this reform, which was a drive for simplification. Rather than simplifying matters for employers, the new rules will continue to be difficult to apply without specialist legal advice.
Opportunity to respond to the consultation
The current consultation relates to the draft legislation in the first instance, rather than to the principles behind it (which the government will argue were the subject of the previous consultation). In that spirit, the questions asked in the current consultation largely relate to detail in the drafting (which is beyond the scope of this alert).
However, there is still an opportunity to provide a general response and comment on the feasibility of applying the new rules. We are considering putting together a response and, for that purpose, would very much appreciate hearing your views on the following points:
- Do you consider that the new rules (if implemented in their current form) will simplify the tax treatment of termination payments and will provide sufficient clarity for employers to apply them consistently and correctly?
- Do you anticipate any particular difficulties in operating the new rules, including from the perspective of payroll managers and with regard to the timing of termination payments?
- Do you anticipate that the new rules could have an adverse effect on negotiations with departing employees?
If you would like to review the current consultation and consider the draft legislation in detail, you can access it here.
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.