Changes To Termination Payments

Sarah Laing outlines the proposed reform of the tax rules governing termination payments as announced in spring Budget 2017.

The term ‘termination payment’ is typically used as a generic summary for a lump sum payment, which is normally (but not always) made to an employee at the time their employment comes to an end. 

The current rules for the taxation of termination payments are complex. There has been scope for employers to manipulate them by structuring arrangements to include payments that would ordinarily be taxable, in order to minimise the income tax and National Insurance contributions (NICs) due. The main area of concern has been whether the existing £30,000 tax-free exemption applies to a payment. Therefore, in an attempt to increase ‘fairness’ and ‘clarity’, the rules governing all termination payments will be reformed from 6 April 2018.

Under the existing rules, it is necessary to look at whether a payment in lieu of notice (PILON) is the contractual right of the employee. Broadly, if a contractual right exists, it will be fully taxable as earnings. This ‘contractual right’ element has provided a degree of scope for manipulating arrangements to take payments outside the taxable earnings boundaries - and in doing so, for potentially escaping the charges to tax and NICs. 

The spring Budget 2017 measure confirms that all PILONs, rather than just contractual PILONs, will be treated as taxable earnings. Therefore, under the new rules, which apply from 6 April 2018, all employees will pay tax and Class 1 NICs on the amount of basic pay that they would have received if they had worked their notice in full, even if they are not paid a contractual PILON. This means the tax and NICs consequences are the same for everyone, and it is no longer dependent on how the employment contract is drafted or whether payments are structured in some other form, such as damages.

The existing £30,000 income tax exemption for genuine terminations payment will remain. However, the NIC rules will be aligned with the tax rules so that, from 6 April 2018, employer’s NICs will be payable on the elements of the termination payment exceeding £30,000. 

The employer’s NICs charge will be achieved through Class 1A contributions. However, the legislation does not set out the way that the Class 1A NIC charge will be collected – this will be set out in secondary legislation in due course. It is expected that the charge will be paid under the PAYE real time information (RTI) system, rather than after the end of the tax year as with other Class 1A NIC charges.

Broadly, foreign service relief (FSR) currently allows termination payments for certain qualifying individuals to be completely exempt from income tax. Employees who receive termination payments while working in the UK, but who have worked for their employer outside the UK for more than 75% of the last 20 years, do not have to pay any income tax. If an employee has worked abroad but does not meet the qualifying criteria for a 100% deduction, they may be able to receive a smaller relief that is proportionate to their time worked outside the UK for that employer.

The government believes that FSR is outdated, unnecessary, and no longer justifiable. FSR will, therefore, be removed from 6 April 2018, although it is to be retained for seafarers. Those who have worked abroad will continue to benefit from the £30,000 tax-free threshold. 

As with most anti-avoidance measures, it is likely that HMRC will monitor how these changes are operated and, if perceived misuse of the rules is detected, further changes can be expected. With this in mind, the spring Budget 2017 proposals also stated that a new power will allow the Treasury to move the £30,000 exemption threshold upwards or downwards. 

Although the existing £30,000 exemption will remain intact, the circumstances in which the exemption can be applied will, in essence, be restricted to genuine redundancy situations. This will remain a contentious area, on which specialist advice is still recommended.