Taxation of termination payments

15 Feb 2017

Many employers will be familiar with the £30,000 tax exemption on termination payments. This was introduced in 2003, and has not been changed since. So when the Government announced it was reviewing the tax regime in this area, one could have been forgiven for hoping that they might have plans to increase the amount of the exemption in line with inflation.

In fact, the Government consulted on a range of measures to change the tax exemptions regime. These included; linking the level of exemption to an employee’s length of service, only applying exemptions to certain types of termination, and removing the distinction between contractual and non-contractual payments.

Following the consultation, happily many of the more complicated proposals seem to have been shelved. However, there are still some changes in the pipeline of which employers should be aware.

The current position is:

  • Compensation payments on termination of employment are exempt from income tax up to £30,000.
  • Such payments are exempt from NI contributions entirely.
  • These exemptions apply irrespective of the reason for dismissal.
  • The exemptions only apply to ex-gratia, non-contractual payments. If an employer is contractually obliged to make a payment, then it will be taxable. This means there is a bit of a grey area in relation to payments in lieu of notice (PILONs). Often, an employee’s contract will include a clause allowing an employer to make a PILON. This means that it is a contractual payment and therefore taxable. If there is no such clause, then it may be considered a non-contractual payment and therefore benefit from the £30,000 exemption. However, that is not certain. If an employer regularly makes PILONs to its employees, HMRC can determine that a PILON clause is effectively implied into all employees’ contracts as a matter of practice and therefore taxable.

The changes that will come into effect from April 2018 are:

  • Compensation payments on termination of employment will remain exempt from income tax up to £30,000. (There is no increase in line with inflation).
  • The position re NI contributions will be aligned with income tax, so that only the first £30,000 will be exempt.
  • Thankfully plans to complicate the system by only applying exemptions to certain types of dismissals have been scrapped. The exemptions will continue to apply irrespective of the reasons for dismissal.
  • To clear up the grey area as to PILONs - all PILONs will be taxable. This will apply whether or not there is a PILON clause in the employee’s contract. However, it will only apply to payments in respect of basic salary for the notice period. If an employer is making a payment in lieu of benefits that would have accrued during the notice period, the exemption will still apply.

 

Additional information