On 6th April 2018, new legislation will take effect which changes the way in which settlement payments are taxed. If you are regularly involved in entering settlement agreements with employees, it will be important to be aware of these changes.
Two key changes relate to the taxation of payments in lieu of notice and taxation on payments which are for ‘injury to feelings’.
Notice pay
A key change is the taxation of payments in lieu of notice (PILONs). At the moment, the tax position is different depending on the terms of the contract. If the employee’s contract contains a clause which provides that their employment may be terminated by making a payment in lieu of notice, the PILON is taxable in the usual way as earnings. If there is no clause permitting a payment in lieu in the contract, terminating an employee’s contract by making a PILON is considered a breach of contract and the payment which is made for the notice period can be considered to be damages, which can be paid tax free.
This is to change from 6th April 2018. The aim of the new rules is to make the taxation of PILONs simpler and avoid manipulation of the rules which results in underpayment of tax. The position going forward will be that all PILONs will be taxable, whether the contract permits it or not.
One difficulty with this is how the relevant payment should be calculated, as PILONs may be based on basic salary only, or be inclusive of bonuses, commission, benefits and so on. The legislation therefore contains a formula for calculating what is termed ‘Post Employment Notice Pay’ (PENP). If an employee is offered a lump sum under a settlement agreement, the formula must be applied to calculate the amount of the PENP, which is taxable. The PENP is then deducted from the lump sum and the remainder is tax-free unless it is taxable for other reasons.
The PENP is calculated with reference to two key factors:
- The employee’s basic pay
- The length of the notice period (or Post Employment Notice Period as referred to in the Act)
Basic pay is considered to be the employee’s salary, excluding any bonuses, commission, benefits, allowances and so on. However, it does include salary which would be included in their salary had they not given up the right to receive it, such as salary sacrifice.
The calculation is made with reference to what is termed the ‘trigger date’. This will either be the day the employment ends (if no notice is given) or the day notice is given. The basic pay is what the employee received in the last pay period prior to the trigger date. Effectively, this requires looking at the date the employee was last paid, and what they were paid on that date. The pay period will be with reference to the frequency with which the employee is paid (i.e. a week or a month).
It must then be considered what the ‘post-employment notice period’ is: the period for which proper contractual or statutory notice would have run had it been given.
The formula for calculation is ((BP x D) /P) – T, which means as follows:
Requiring employers to:
• Multiply basic pay by the number of days/months in the notice period;
• Divide that figure by the number of days/months in the last pay period; and
• Then subtract any payments which are already taxable.
In many cases, this calculation will be more straightforward than it looks, particularly if there are no other taxable payments.
Statutory redundancy payments will be exempt from the calculation. Therefore, if an employee is being made redundant, the calculation does not need to be carried out on their statutory redundancy payment, although it will need to be considered in relation to any enhanced pay. If no notice is given, the employee will be entitled to pay in lieu of their notice which will need to be taxed accordingly.
In many cases, a more straightforward way to consider matters will be to separate notice pay from any lump sum payment from the outset, although it may be helpful to do the PENP calculation to ensure the taxable notice pay is calculated correctly.
There are some cases where the application of the new formula may cause more difficulty. Generally, if there is a PILON clause in the employee’s contract the PENP calculation will not need to be done. However, there are some circumstances (such as cases of salary sacrifice) where the PENP calculation may give a difference notice pay figure to the calculation of the PILON in terms of the contract. The rules may also create difficulty in cases where there has been an alleged unfair dismissal, as no notice would be paid for a summary dismissal. However, if the matter is subsequently settled and notice pay is part of the agreed figure, there is not yet any guidance on how the calculation should be carried out. Until there is more clarity on this, it may be advisable to err on the side of caution in difficult cases and pay tax on the higher amount, which can later be recouped if this is not correct.
It should be noted that the new rules apply to trigger dates after the 6th April 2018. Therefore, if an employee’s employment terminates prior to that date, the new rules on taxation will not apply to that agreement.
It is hoped that more guidance from HMRC will be available in the coming months to ensure that the new rules are being correctly applied. In many cases, the calculation of notice pay for tax purposes will be relatively straightforward, but care should be taken to ensure that there are no circumstances which complicate matters. Consideration should be given as to what the sums being paid to the employee are for, and ensuring that tax is paid accordingly.
It should also be noted that from April 2019 there will be a further change which provides that employers will have to pay National Insurance Contributions for settlement payments on amounts which exceed the £30,000 exemption, which will affect the cost of entering into settlements greater than exemption figure.
Injury to feelings
There is also a change to how payments for ‘injury to feelings’ are treated for tax purposes. This type of payment is generally made where there has been an allegation of discrimination or whistle blowing. Previously, this type of compensation has been considered to be tax free. However, the legislation simply refers to ‘injury’ and the upper tier tax tribunal has previously held this must be considered to be actual physical or psychiatric injury, rather than simply upset. The new legislation now clarifies this and confirms that payments for injury to feelings are not exempt from tax, unless the injury relates to an actual psychiatric or mental health condition from which the person is suffering.
For further advice on this and other employment related matters please feel free to contact Miller Samuel Hill Brown.
