Changes to the taxation of PILON Payments
The government has embarked on a series of reforms to the tax and NICs payable on termination payments with the aim of "clarifying and tightening" the tax treatment of such payments.The new legislation will also remove the differing tax treatments which currently apply to contractual and non-contractual payments in lieu of notice (PILON).These changes will come into force on 6 April 2018.
Current position in relation to PILONs
Currently, contractual PILONs (i.e. payments made pursuant to a PILON clause in the employment contract) are treated as fully taxable earnings, and are therefore subject to deductions for income tax and National Insurance contributions (NICs).
Where the contract does not provide the employer with a contractual right to make a PILON, and the payment is not an "auto-PILON" (i.e. made as an automatic response to termination of employment) and is instead paid as damages for failure to provide an employee with their notice entitlement then such a payment will be taxed under sections 401 - 403 Income Tax (Earnings and Pensions) Act 2003 (ITEPA) and will therefore benefit from the £30,000 tax-free exemption.Only the amount in excess of £30,000 will be subject to income tax (but currently not NICs).
Effect of new legislation
From 6 April 2018, a new regime applies to PILONs paid on termination of employment.The intention is to tax (and subject to class 1 NICs) as earnings the basic pay an employee would have earned had the employee worked their notice in full regardless of whether there is a contractual right to make a PILON or not.
The new provisions of ITEPA require the employer to split a termination award between amounts treated as earnings and amounts benefitting from the £30,000 exemption.This effectively means that from 6 April 2018, employers must treat a slice of a termination award, which reflects basic pay for any part of a notice period that is not served, as earnings and subject that slice to tax and NICs (both employer and employee).
To calculate the correct portion of the termination payment which will be taxable involves applying a formula to calculate the employee’s "post-employment notice pay" (or, since we like to use acronyms, PENP).
PENP is effectively an amount equivalent to the employee’s basic pay for any period of unworked notice.Basic pay for this purpose will be based on the employee’s basic pay for the last pay period, which importantly includes any additional sums which the employee has otherwise given up through salary sacrifice arrangements.Credit is then given (in the form of a deduction in the calculation of PENP) for any contractual PILON that is paid (effectively avoiding double tax).Once PENP has been calculated, that amount will be re-characterised as a fully taxable notice payment.
As a result, only the amount of the termination award in excess of the employee’s PENP (if anything) will benefit from the £30,000 exemption.
The only termination payments which are not tested against PENP and which will continue to benefit from the £30,000 exemption are statutory redundancy payments.Enhanced redundancy payments will therefore not necessarily benefit from the £30,000 exemption and will be included in the amount tested against PENP.
So, time to brush off your maths skills.The formula for calculating PENP is BP x D – T where:
- BP is basic pay;
- D is the number of months in the PENP (i.e. the period of unworked notice); and
- T is amounts that are paid on termination but are taxable as earnings.
So, as a very basic example, an employee is paid £4,000 per month and has a three month notice period.The employee works one month of their notice period and the employer makes a settlement payment of £15,000.
Applying the formula: BP (£4,000) x D (2) – T (Nil) = £8,000.
£8,000 is therefore treated as earnings and subject to tax and NICs with the balance (£7,000) benefitting from the tax free exemption.
A more complicated formula is applied if the employee is not paid monthly or the employee's notice period or unworked period of notice is not expressed in months.
The PENP calculation may result in a higher amount being subject to tax than if the employee had received a "normal" PILON payment.This is because the basic pay figure for the purposes of calculating PENP will include any additional amounts by way of salary sacrifice.
So what does all of this mean in practice?
- If employees are working their notice period then there is no issue.
- If you are making a PILON in the normal course of termination of employment (and not by way of a settlement agreement) then there is no issue and you would simply pay their notice payment through payroll in the normal way.
- If the employee’s PILON payment is being rolled up into a termination payment and being paid through a settlement agreement, then you will need to tax the proportion of that termination payment that reflects the notice period.However, care does need to be taken that the correct figure is being subject to tax, and this is where the above calculation comes in.This is a technical point and is not always going to be a straightforward calculation, particularly where a salary sacrifice scheme is in place and/or the employee’s notice period and pay period is not expressed to be in months.
Another date for your diary
In addition to the above reforms, from 6 April 2019 all termination payments which exceed £30,000 will be subject to employer’s class 1A NICs.
What should you be doing?
If you have any ongoing settlement negotiations with employees where you can potentially apply advantageous tax treatment to a notice payment you should look to conclude these before 6 April 2018 (with the termination date being before this date), otherwise the tax savings will be lost.
Going forward, you will need to factor in the additional NICs consequences of termination payments and this may affect the level at which you are willing to settle. If you are concerned about how to apply the correct formula when calculating PENP (or even whether this applies to a proposed settlement), please do get in touch with one of our Employment Team.
These changes may well encourage you to review your contracts of employment and include PILON clauses where there previously were none. There now appears to be no advantages of not including a PILON clause and will ensure that the benefit of any restrictive covenants is preserved upon termination (which might otherwise have lapsed if the contract was terminated in breach of the notice provisions).
If you would like to discuss any issues raised in this article, we have specific employment law expertise in advising in this area. For further advice, please contact Kathryn Moorhouse on firstname.lastname@example.org or 0113 280 2231.
Please note this information is provided by way of example and may not be complete and is certainly not intended to constitute legal advice. You should take bespoke advice for your circumstances.