The Taxation of Termination Payments

The rules governing the taxation of termination payments have been tightened with effect from 6 April 2018 by means of legislation to amend Chapter 3, Part 6 of the Income Tax (Earnings and Pensions) Act 2003.

Hitherto, where the employee's contract of employment contained an express payment in lieu of notice (PILON) clause, such payments were taxed at the appropriate rate. Where a PILON was not contractual, and the business making it did not routinely make such payments to departing staff, it could be regarded as compensation for breach of contract and paid free of tax up to a threshold of £30,000.

In order to ensure that the £30,000 exemption cannot be abused, the distinction between contractual and non-contractual PILONs has now been removed. The change applies to payments or benefits received on or after 6 April 2018, whether contractual or non-contractual, in circumstances where the employment also ended on or after 6 April 2018.

Employers are now required to calculate the amount of basic pay excluding bonuses, referred to as post-employment notice pay (PENP), the employee would have received had they worked their full notice period. This amount is taxable as earnings and subject to Class 1 National Insurance Contributions (NICs).

The first £30,000 of a termination payment that is not PENP remains exempt from Income Tax, and any payment made to any employee that relates solely to the termination of their employment will continue to have an unlimited employee NICs exemption. The proposal to subject all termination payments above the £30,000 threshold to employer NICs, which was originally due to take effect at the same time, has been delayed until April 2019.

The legislation ensures that PENP calculations are not to be applied to statutory redundancy payments. These are always taxable as specific employment income and subject to the £30,000 exemption where appropriate.

A further change is that Foreign Service Relief in respect of termination payments is to be removed. This will not apply to seafarers, however.

In addition, the legislation clarifies that the exemption from tax for payments for injury and disability is not intended to apply to payments for injury to feelings, except where the injury amounts to a psychiatric injury or other recognised medical condition.

Detailed guidance can be found in the Employment Income Manual, updated as of 16 April 2018.