Sarah Laing outlines recent changes to the income tax and National Insurance contributions rules governing lump sum payments when an employee leaves their job.
For many years, complex rules have governed the way in which payments made to employees leaving employment should be taxed. Broadly, the term ‘termination payment’ has been used as a generic summary for any lump sum payment, which meant there was scope for employers to manipulate the rules by structuring arrangements to include payments that would ordinarily be taxable in order to minimise the income tax and National Insurance contributions (NICs) due. So, in an attempt to increase fairness and clarity, the rules governing all termination payments are being reformed from 6 April 2018.
PILONs
Under the pre-April 2018 rules, it was necessary to look at whether an employee had a contractual right to payment in lieu of notice (PILON). In simple terms, if the employee’s contract specified entitlement to such payment, the payment would be fully taxable as earnings. However, this ‘contractual right’ element 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.
Changes to the rules (enacted by F(No 2)A 2017, s 5) provide that, from 6 April 2018, all PILONS, rather than just contractual PILONs, are treated as taxable earnings, meaning that employees will pay tax on the amount of basic pay that they would have received if they had worked their notice in full. The NIC rules have also been aligned with the income tax rules, which mean that employees (and employers) will also have to pay Class 1 contributions on such payments, regardless of any contractual entitlement.
Exempt payments
Although the existing £30,000 income tax exemption for genuine terminations payment has not changed, the reforms to the tax and NICs rules mean that, for payments on or after 6 April 2018, employer (but not employee) NICs will be payable on the elements of the termination payment exceeding £30,000.
Whether or not a payment qualifies as a ‘genuine redundancy payment’ is likely to remain a contentious area for discussion, and one on which specialist advice continues to be recommended.
The legislation does not contain a definition of ‘redundancy’ but ITEPA 2003, s 309 (which provides the exemption for statutory redundancy payments) refers to the definition in the Employment Rights Act 1996, s 139.
In view of the continuing favourable tax treatment for genuine redundancy payments, HMRC are likely to scrutinise any claim that such a payment has been made. Specifically, HMRC will wish to be clear that a redundancy payment made to a departing employee is not one of the following:
- a long service award;
- a contractual payment that is merely triggered by the fact that the employee is leaving;
- a restrictive covenant payment;
- payment in lieu of notice;
- payment for ‘garden leave’;
- non-approved pension payment; or
- payment to acquire shares from the departing individual.
Looking ahead
HMRC will no doubt be monitoring how the reforms are operated. Finance (No 2) Act 2017, s 5 (inserting new ITEPA 2003, s 404B) already gives the Treasury the power to move the £30,000 exemption limit upwards or downwards, so if misuse of the rules is detected, we are very likely to see further changes being made.
Practical Tip:
HMRC operate a formal clearance procedure for checking whether a redundancy payment will qualify for the £30,000 exemption. The clearance will be binding on HMRC as long as the employer has made a full disclosure of all relevant facts (see HMRC’s Employment Income manual at EIM13790).
