Category Archive: Tax

April 2018 tax reforms will impact on employers making termination payments

Employers who are planning to make termination payments to departing employees on or after 6 April 2018 need to be aware of important reforms which will take effect on 6 April 2018.

The key point for employers to note is that the value of all notice periods not worked will become taxable and subject to both employer and employee National Insurance Contributions (NICs), regardless of whether there is a contractual payment in lieu of notice (PILON) clause, or not.  This is a critical change to the existing position, where currently the value of a notice period can generally be paid tax and NICs-free where there is no contractual PILON clause in the employee’s contract of employment.  The impact of this is to potentially increase costs to employers who may have to increase the value of a termination package to make it sufficiently attractive to an employee.  It also makes the tax advantages of not having a PILON clause redundant, and increases the benefits of including one, not least so that any restrictive covenants will remain enforceable post-termination.

Payments made pursuant to a contractual PILON clause have always been – and will remain –  subject to tax and NICs in full as general earnings.

So, in practice, what impact does the legislation have?  In effect, it does not matter how much of the severance package the employer allocates to notice.  What the new provisions require is that employers carry out a specific calculation to determine how much of the termination payment is deemed to be subject to tax and NICs as ‘post-employment notice pay’ (PENP).  For these purposes, only basic pay, plus the value of any salary sacrifice arrangements, is taken into account. Once the value of the PENP has been established, any remainder of the payment will be subject to the £30,000 tax free exemption (so any remaining payment up to £30,000 will be free of tax and NICs, and anything in excess of £30,000 will be subject to tax only[1]).

In many cases, the impact of the new legislation in practice (other than making non-contractual PILONs taxable) will be fairly limited, and the calculations relatively straightforward. This is particularly the case where an employee’s notice period is a whole number of months.  However, the position is less straight forward where an employee’s notice period is expressed in weeks, where the calculation may become skewed by the date of the employee’s departure. It is also more complicated where salary sacrifice arrangements apply.  This is key as it is common for contractual PILONs to confer entitlement to basic pay only, whereas the new calculations require the value of any salary sacrifice to be added on.  Where salary sacrifice arrangements are in place, therefore, there will be an impact on the value of the PENP (and therefore the amount subject to tax and NICs), which will be higher than would apply if calculations were done by reference to the provisions of the contractual clause only. This may mean that, even where there is a contractual PILON and the employer has deducted tax and NICs on the notice pay actually paid, the PENP calculation results in an additional tax and NIC liability.

If you have any queries about the new tax regime for termination payments, please speak to your usual DLA Piper Employment contact or David Smith or Lynda Finan in our Tax team.

[1] NB From April 2019, further tax reforms will mean that any excess over £30,000 will be subject to employer’s NICs.

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Termination payments – changes to the tax treatment

Following its consultation in 2015, the Government has now confirmed the changes which will be made in how termination payments will be taxed, and published draft legislation for comment.

The changes will apply “from April 2018”. It is not clear at this stage whether payments pursuant to settlement agreements entered into before that time will be grandfathered under the existing legislation, but that may well be the case.

Key points are:

  • the existing £30,000 income tax exemption for termination payments will continue to apply, as will the unlimited exemption for employee national insurance contributions (“NICs”) (provided, as now, the payment is not “earnings”). However, employers’ NICs will be due on any termination payment in excess of £30,000, making termination payments more costly for employers;
  • all PILONs will now be taxed (irrespective of whether they are contractual or non-contractual). In fact, any payment or benefit which the employee would have received during his notice period (had he worked it) will be subject to tax and NICs Further details of how this provision will operate in practice are set out below;
  • the exemption for payments due to injury and disability will be retained, but will be amended so that it will not extend to injury to feelings unless the injury amounts to a “psychiatric injury or other recognised medical condition”;
  • foreign service relief will be withdrawn. This may raise some interesting questions, for example, about whether a payment to an employee who has worked outside the UK for several years but for a UK employer, will be caught;
  • the other existing exemptions will remain, including payments made to tax exempt or registered pension schemes, and in respect of legal costs.

PILONs, contractual and non-contractual payments

The intention is that any payment which an employee would have been entitled to receive had they worked their notice period will be subject to tax and NICs and fall outside the £30,000 exemption. Any other (non-contractual) termination payments will continue to benefit from the £30,000 exemption.

The draft legislation works as follows:

  • the employer must calculate the aggregate amount the employee would have been entitled to had he worked for the remainder of his notice period (“PB”). PB is calculated by aggregating the following sums:

(i) “P”: this is essentially the amount of general earnings which would have been earned by the employee during that part of the “minimum notice” period which is not actually worked, calculated by reference to the employee’s earnings for the 12 weeks prior to the end of employment (where no notice to terminate is given) or prior to the giving of notice (where notice is given).  If the full minimum notice period is worked, this number will be zero.  The “minimum notice period” is the minimum notice required to terminate the employee’s employment in accordance with law and his contractual terms.  Anti-avoidance provisions will apply to prevent artificial reduction of earnings during the 12 week testing period; and

(ii)  “B”: this is the amount of any bonus, commission, incentive “and anything similar” that the employee could reasonably be expected to receive before the end of the employment (including during the minimum notice period) and which is not received before the employment ends;

  • if PB exceeds the amount of the termination payment (excluding any payment by way of compensation for unfair dismissal or redundancy), the full termination payment will be taxable.       If PB is less than the amount of the termination payment (after the same exclusions), the amount of PB is taxable, but the excess will attract the £30,000 exemption.


Employee A:

Employee A is made redundant after 15 years’ service. A is required to work the minimum statutory notice period of 12 weeks. A’s gross salary is £28,000 per year and A is entitled to a statutory redundancy payment of £8,400.

During the notice period, A continues to receive salary. This amounts to £6,450 over the 12 week period. This will be subject to tax and NICs as earnings.

When the employment is terminated at the end of the 12 week notice period A receives a total termination package of £17,400 under a settlement agreement, including the statutory redundancy pay.

Tax treatment: Employee A has worked his entire notice period and is receiving a termination payment that is non-contractual. The full payment benefits from the £30,000 exemption and so no tax or NICs arises.

Employee B:

Employee B resigns giving 6 months’ notice as required by his contract of employment. His gross salary is £80,000 per year. He earns commission of (typically) £1,200 per month and receives a car allowance of £800 per month.

He works 8 weeks of his notice period whilst negotiating a settlement agreement with his employer and is paid £12,308 gross salary (8 weeks’ pay), £2,400 commission and  £1,600 car  allowance.

The employer makes a payment in lieu of notice of £27,692 (which is the amount of salary he would have received had he worked the balance of his notice period) and an ex gratia payment of £25,000. In accordance with the terms of his employment contract, the other benefits which Employee B receives in addition to salary are not taken into account for the purposes of calculating the PILON. The full termination payment is therefore £52,692.

Tax treatment: Employee B has not worked his full notice period. Had he continued in employment for the full notice period, he would have received £35,692 (i.e. salary of £27,692 (which is “P” on the “PB” formula), commission of £4,800 and car allowance of £3,200 (which together are “B” in the “PB” formula)).  Accordingly, £35,692 of the termination payment is subject to tax and NICs.  The balance of the termination payment (being £17,000) falls within the £30,000 exemption.  This contrasts with the current law under which the employee would have expected to receive (at least) the full ex gratia payment of £25,000 without tax deductions.

How we can help

Employers need to be aware of the changes and ensure that the correct amount of tax and national insurance contributions are deducted from termination payments since the primary liability for any shortfall is that of the employer.  In addition to advising on employee terminations and settlement agreements, we can assist you in understanding and applying the new rules correctly.   In advance of the legislation being implemented, employers may also want to revisit the notice provisions in employment contracts so that they are consistent with the requirements of the new rules.

For further information,  please contact David Thompson, Nick Hinton or Lynda Finan from our Tax Group.



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Termination payments briefing series: payments for injury to feelings

This is the first in a series of briefings on termination payments, focusing on the tax treatment of payments made in respect of injury to feelings paid in connection with termination of employment.

Moorthy v HMRC: where are we now?

The correct tax treatment of payments made in respect of injury to feelings paid in connection with termination of employment has for some time been uncertain as a result of conflicting case law. The recent Upper Tribunal decision in Moorthy v HMRC means that in most cases, HMRC will now seek to tax such payments.

Moorthy was a redundancy case where the taxpayer claimed that he had been unfairly selected for redundancy on the grounds of his age.  He alleged age discrimination and unfair dismissal.  He entered into a compromise agreement and claimed that the payment made by his employer was tax free as it was paid to compensate him for injury to feelings.

Payments made on termination of employment which are not otherwise taxable either as earnings or under any other section of the employment income tax code, fall into section 401 Income Tax (Earnings & Pensions) Act 2003 (Section 401). Section 401 brings within the charge to income tax any payment or benefit received “directly or indirectly in consideration of or in consequence of, or otherwise in connection with, a termination of employment”.  This is subject to a series of exemptions, including for the first £30,000 of the termination payment and a further exemption (unlimited in amount) in Section 406 for payments or benefits made “on account of injury to, or disability of, an employee”.  It was this further unlimited exemption which the taxpayer in Moorthy relied on, and which the Upper Tribunal rejected.

Timing of the payment: is it connected with termination of employment?

Section 401 only applies to payments which are made in connection with the termination of employment (or a change in duties). Payments for discrimination which are not connected with a termination of employment should not normally be taxable: they are not within section 401 and are not “earnings”.  This applies whether the payment is to compensate for financial loss arising out of the discrimination or for injury to feelings.

Where the payment is made in connection with a termination of employment, Section 401 must be considered. It is in relation to such payments that the Tribunal in the Moorthy case rejected the approach in previous cases and held that a payment for injury to feelings is taxable.

The decision in the Moorthy case

The Tribunal in the Moorthy case decided two key points:

  • That damages for injury to feelings for discrimination paid in connection with termination of employment are in principle taxable under Section 401 whether they relate to financial loss or injury to feelings, because the discrimination and the payment are both connected with the termination. In an earlier case, a lower Tribunal had distinguished between payments made on termination for financial loss (taxable) and payment for injury to feelings for discrimination (not taxable), on the basis that the latter was not compensation for termination but was compensation for the earlier discrimination. The Tribunal in the Moorthy case criticised this approach on the basis that this distinction was irrelevant and the correct question was whether there was a connection between the payment and the termination of employment; and
  • That damages for injury do not fall within the exemption in Section 406 unless they amount to a medical condition which prevents the employment being carried on. The exemption will not normally therefore apply to damages for “injury to feelings”. Previous cases in the employment tribunals had not limited the exemption to injury causing a medical condition preventing the employment being carried on.

Where are we now?

The key question is whether the payment is connected to termination of employment:

  • If there is no termination of the employment, Section 401 cannot apply. The only question then is whether the payment is “earnings”. It seems reasonably clear that damages for discrimination are not earnings and therefore not taxable. Other payments for injury to feelings should be similarly treated. The Moorthy case has not changed the position here.
  • If the termination of employment itself constitutes the discrimination, as in the Moorthy case, then all payments are connected with the termination of employment and fall into the Section 401 code. Following Moorthy (which HMRC is likely to apply in all cases now unless and until it is successfully appealed) payments for injury to feelings will be taxable in the same way as a payment to compensate for financial loss.
  • The position is now less clear if the discrimination occurred before termination of employment but leads to it, for example, where the employee claims constructive dismissal because of discriminatory treatment. HMRC’s guidance currently states that in the case of compensation for injury to feelings, if the discrimination occurred before the termination of employment, this is not taxable. In light of Moorthy, HMRC may very well now argue that the payment is connected with termination of employment in these circumstances and seek to tax the whole payment. Employers will therefore need to consider the position carefully.

Employers can no longer rely on the “injury to feelings” exemption in Section 406 unless that injury amounts to a medical condition which results in termination of employment.

For further information please contact Lynda Finan, David Thompson or Nick Hinton.


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