Following consultation, changes to the income tax and National Insurance treatment of termination payments have been confirmed. The government’s decision to delay the National Insurance Bill however, means that some of the changes will be deferred.
Position to 5 April 2018
Payments made compensating employees for their loss of office are tax free up to £30,000 and are entirely exempt from National Insurance. This exemption is a ‘sweep-up provision’ that only applies where the payment is not taxed under another heading (such as accrued remuneration or restrictive covenants).
Payments In Lieu Of Notice (PILONs) which derive from an employment contract (whether discretionary or not), another employment agreement or are paid automatically, habitually or as custom by an employer are not considered to be compensation payments but instead are subject to income tax/and National Insurance contributions (NIC as remuneration. This treatment is the same as for other contractual payments made on termination of employment such as accrued bonuses and payments in lieu of unused annual leave. By way of contrast, PILONs that are non-contractual and which the employee has no expectation to receive are considered compensatory and therefore can be paid free of tax (subject to the overall £30,000 cap) and NICs.
Statutory Redundancy Pay is automatically free of tax and NICs, but counts towards the £30,000 limit.
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 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 of 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 deduction are instead entitled to a proportionate deduction. 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 will change, and some amounts will become subject to both employer’s and employee’s NICs, as outlined below.
Payments in Lieu of Notice
All PILONS, on whatever basis they are paid, will be treated as earnings and subject to tax and NICs accordingly.
Where there is no separate PILON paid as part of the 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 considered earnings liable to tax and NICs.
This is calculated by multiplying the employee’s basic annual salary (excluding bonuses, commission, 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 £50,000 and three months’ notice will have a deemed PILON of £12,500 (£50,000 x 3/12).
Qualifying termination payments
Any balance of the total settlement after this carve-out, and which does not separately fall to be taxed as remuneration/restrictive covenants etc, would be considered to represent compensation for loss of office. The £30,000 exemption will still be available to offset against any such amounts, with the balance subject to income tax. Although the ultimate intention is to introduce an employer’s NIC charge on amounts over the £30,000 exemption, this will not be introduced until April 2019. For the period 6 April 2018 to 5 April 2019, therefore, any such payments will be taxable, but NIC-free.
Foreign Service Relief
Foreign Service Relief is to be removed where the employee was tax resident in the UK in the year the employment was terminated. For employees who were non-resident in the UK in the year of termination, the existing rules as outlined above remain in place (ie all or some of the payment can be exempted from UK tax).
Potentially, this could result in a significant increase in UK tax for employees working overseas but who have not broken UK tax residence, especially where there is no double tax treaty protection enabling the taxpayer to offset this additional UK tax against foreign income tax due on the payment. Even where a double tax treaty is in place, this may not provide protection against being taxed twice as this would require both countries to consider the termination payment to represent earnings from employment. This will not always be the case as the payment could be considered to represent damages and therefore not employment related.
Furthermore, where double tax relief is available, employees may face a significant delay in recovering overpaid tax. Generally speaking, it will only be possible for the employer to take account of any foreign tax where they are operating an ‘Appendix 5’ (net of foreign tax credit) agreement. Otherwise, the full income tax due will need to be deducted under PAYE, and the employee will have to reclaim through the self assessment system.
For employers the changes represent an additional burden in that they will need to know the employee’s personal tax residence position. This could require the employer to have knowledge (which they may not necessarily hold) of the employees personal circumstances, such as family and accommodation ties to the UK. Furthermore, in some cases it will not be possible to determine an individual’s residence position until after the end of the tax year – some time after tax should have been reported and paid under PAYE Real Time Information reporting. We hope, therefore, that HM Revenue & Customs (HMRC) will use its guidance to clarify how employers should go about determining residence in these situations, and what is expected where the individual’s final residence position is different from that predicted at the time the payment was made.
Changes from April 2019
As outlined above, the government’s intention is to bring employer’s NICs into line with the income tax position (ie only the first £30,000 of any compensation payment will be exempt), whilst retaining a full exemption from employee’s NICs. In order to achieve this, the employer’s NICs will be imposed under Class 1A (usually applicable to benefits in kind).
Extending the Class 1A charge in this way will require primary legislation, and the original intention was for this to be included in a National Insurance Bill in late 2017. However, the government announced in November 2017 that the Bill would be delayed, and, in consequence, the Class 1A charge will not take effect until April 2019.
Items chargeable to Class 1A NICs are usually declared and paid via the P11D process with reporting deadline of 6 July following the end of the tax year in which the payment was made and the NICs payable by 19 July following the tax year of payment.
However, HMRC has indicated that the Class 1A charge on termination payments will be collected through PAYE RTI, with both reporting and payment due on or before the time the payment is made. Further guidance is awaited as to how this in-year Class 1A charge will operate in practice.
Employers are advised to take this opportunity to review their current termination and redundancy policies to ensure that they are fit for purpose and will be tax/National Insurance compliant when the changes are enacted. Employers should also consider informing their employees on the impact of the changes, especially where the employee has spent time working outside the UK.
If you have any questions on how this could impact you, your company or your employer, please contact your usual Saffery Champness partner.