There are new tax treatment provisions, which take effect from 6 April 2018 and, some which have been delayed to April 2019.
The position to 5 April 2018
The current regime is that payments made compensating employees for their loss of office are tax free up to £30,000 and are entirely exempt from both employer and employee’s national insurance contributions (NICs). This exemption only applies where the payment is not taxed under another heading, for example, income deriving from employment or in consideration of entering into restrictive covenants.
Where the employment contract specifies a payment in lieu of notice (PILON) this is treated as income deriving from the employment contract, whether or not such payments are discretionary or are paid automatically or by custom and practice. Because they are not considered a compensation payment for loss of employment, these payments are subject to both income tax and NICs. This treatment is the same for other contractual payments made on the termination of employment, such as accrued bonuses and outstanding holiday payments.
So it is by way of contrast that non-contractual payments and payments which the employee has no expectation to receive are considered compensatory and therefore come within the tax free exemption up to the cap of £30,000. Statutory redundancy pay is automatically free of tax and NICs, but counts towards the £30,000 limit.
Foreign Service Relief
Employees who have spent periods working abroad and were non-UK tax resident for part of the period covered by the termination payment are entitled to a reduction known as “Foreign Service Relief” in respect of the amount taxable in the UK. The entire payment will be free from UK tax and NICs where the overseas period meets one of the following conditions:
- It is at least 75% of the total service;
- It covers the entire last 10 years; or
- For service over 20 years, it represents at least 50% of the service (including 10 of the final 20 years).
Employees who have spent periods working abroad and were non-tax resident for part of the period but are not entitled to a full reduction are instead entitled to a proportionate reduction. This reduction is effective after taking into account the £30,000 exemption.
Tax treatment with effect from 6 April 2018
From 6 April 2018 the income tax position is changing. The most important change relates to the treatment of PILONS.
Under the new regime a PILON on whatever basis it is paid will be treated as income deriving from the employment contract and will be subject to income tax and NICs (both employer and employee).
In the event that no separate PILON is paid as part of a total settlement, an amount equal to the PILON that would have been paid, either by reference to the employment contract or implied statutory rights, will be carved out of the payment and treated as earnings liable to income tax and NICs.
This will be calculated by multiplying the employee’s basic annual salary (excluding bonuses, commissions, benefits etc) by a fraction found by dividing the number of months’ notice the employee is entitled to by 12. For example, an employee with a basic salary of £60,000 and 6 months’ notice will have a deemed PILON of £30,000 (£60,000 x 6 / 12).
Any balance of the total settlement over and above the PILON and which does not separately fall to be taxed as income deriving from employment, can take advantage of the £30,000 exemption with any further balance over £30,000 being subject to income tax only. The intention had been to introduce an employer’s NIC charge on the amounts over £30,000 exemption, but this has been delayed until April 2019.
Foreign Service Relief
Foreign Service Relief is to be removed where the employee is tax resident in the UK in the year the employment is terminated. For employees who are non-resident in the UK in the year of termination, the existing rules as outlined above remain in place.
Changes from April 2019
The UK government had intended to bring in a further change to employer NICs to bring it in line with the income tax position charged on compensation payments over £30,000. The provision is delayed until 6 April 2019 when any payments over the PILON and £30,000 exemption will be charged to income tax and employer’s NICs but retaining the exemption on employee’s NICs.
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