Taxing exit payments: Frequently Asked Questions

On the 6 April 2018 new rules on the tax treatment of termination payments came into force. 

The new rules treat all payments in lieu of notice (PILONs) as earnings, which means that they are subject to tax and NICs, regardless of whether they are contractual or not. This change will have a real impact on the settlement figures/ payments on termination that businesses may be able to pay departing employees as well as important changes to the drafting of settlement agreements. Employers are advised to take this into account in the early stages of negotiations with employees to avoid having to subsequently change their approach to financial packages offered.

Below we consider some of the frequently asked questions from employers surrounding these post-employment notice periods (PENP) and the application of the new tax treatment to PILONS;

1. Is it possible to make a tax-free termination payment under a settlement agreement post April 2018, if there is no mention of a PILON in the agreement and no PILON clause in the contract?

Prior to the changes that came into place on the 6 April 2018, if the employment contract did not contain an express PILON clause ( or implied / discretionary PILON and the employer did not have a standard practice of making a PILON), a PILON payment could be made under a settlement agreement tax- free.

However, from the 6 April 2018 this will no longer be the case. The changes mean that where any part of a termination payment relates to notice pay, it will be subject to tax and NICs as earnings, regardless of whether there is a PILON clause in the contract or not.

2. What happens when there is a contractual PILON that is being made in full? Do we still have to use the new formula?

Yes, even where there is a PILON in the contract you still need to apply the new formula to the termination payment being made. You should use the new formula in all cases where the full contractual period is not worked, even if the full intention is to apply tax and NICs to the full contractual PILON. This will ensure that the correct amount of tax is paid and, unfortunately, there may still be some situations in which an additional sum ought to be subject to deductions.

3. Should an employer use the PENP calculation when a termination payment is made following summary dismissal for gross misconduct?

Unfortunately, HMRC is yet to provide guidance on this point, so if you come across this scenario it is recommended that you take legal advice. However, our current understanding is that, in those circumstances, the PENP calculation should still be applied to the part of the termination payment that may be deemed to relate to notice.

4. Where an employee has agreed to contractual notice that is less than statutory, is any payment made in excess of the agreed notice payable tax free under a settlement agreement?

HMRC are yet to issue guidance on this point, so again it is advisable to seek legal advice if you come across this scenario.

The difficulty with this particular situation is that the definitions of "post-employment notice period", "minimum notice" and "earliest lawful termination date" in ITEPA 2003 seem to imply that the calculation should use the length of the unexpired contractual notice, or the statutory notice, whichever is longer. However, if an employee waives their right to statutory notice and this shorter period is used in the calculation then this will affect the PENP calculation.

It is important to note that the new rules do include an anti-avoidance test, which can be used by HMRC to correct payments if arrangements are being entered into for the purpose of avoiding tax.

5. Have HMRC revised the Employment Income Manual to reflect the changes to taxation of termination payments?

HMRC have revised numerous pages of the Employment Income Manual and inserted new pages to reflect the changes to the taxation of termination payments. Here’s a link to the updated contents page: HMRC, Employment Income Manual, Termination payments and benefits: contents. There are also some example PENP calculations, which can be found at EIM14000.

If you are in any doubt about the tax implications of any termination payments that you are proposing to make, we would recommend that you seek further legal advice, to ensure compliance with the new regime.