22 Jan 2018

Proposed changes to termination payments

14 June 2017

Changes ahead


  • Changes to the treatment of termination payments were shelved before the general election but are likely to reappear in a new bill.
  • New concept of ‘post-employment notice pay’ will exclude elements of a payment from the £30,000 exemption.
  • Employers’ class 1 National Insurance will be due on taxable payments.
  • Payments to internationally mobile employees may be taxable if the employee has worked in the UK.

The Finance (No 2) Bill 2017 gave details of proposed changes to the rules on the tax and National Insurance treatment of termination payments. These provisions were removed from the Finance Act 2017 but they are expected to resurface later in the year and the article proceeds on that assumption.

The changes were mooted in a consultation last summer. Many were not replicated in the draft legislation as a result of feedback from the consultation, but there will still be some significant changes, most of which will take effect from 6 April 2018. However, given the long lead times and consultation periods required when staff are paid a termination settlement, employers will need to consider these changes well in advance of that date to ensure sound cost projections, policies and procedures are in place.

Statutory references are to ITEPA 2003, unless otherwise stated.


Status quo

Before addressing the changes it is worth reiterating the status quo. When tax advisers talk about a ‘termination payment’, they are referring to one that is subject to tax under ITEPA 2003, s 401, the provision which taxes payments in connection with a termination of employment. This terminology can lead to confusion because, in practice, many sums paid on the termination of an employment may be taxable as earnings under s 62. Equally, payments could be taxable under other provisions, such as Pt 7 (employment related securities), or not taxable if they are an award for damages.

All of this makes it difficult for employers to decide whether a payment should:

  • be subject to PAYE in full;
  • qualify for the £30,000 exemption;
  • be paid gross; and
  • attract National Insurance.

Some situations are clear but others are less black and white. If a payment is for redundancy, it is subject to the £30,000 exemption. If it is for gardening leave, it will be taxable under s 62. Most of us would say that an ex-gratia payment for loss of office is taxable under s 401. But what if the amount was calculated by reference to a bonus that an individual would have received had they stayed in employment or simply amounts to an accelerated vesting of some share awards? These greyer areas tend to be where disagreement arises between any combination of the employer, the employee, the employee’s solicitor and HMRC. Couple this with the fact that relations between the parties are often frosty and there is a recipe for conflict, usually with an adviser caught in the middle.



Do the changes make matters clearer or will uncertainty in one area be replaced by uncertainty in another?

Those who read the consultation document will recall that the original proposal was to replace the £30,000 exemption with one that increases over time depending on an employee’s length of service. This was dropped and the fixed £30,000 exemption remains. Instead, the new rules focus on determining whether a payment will be taxable in the same way as salary or other general earnings, or if the £30,000 exemption can apply.

The proposed s 402A provides that, if the termination payment is not general earnings, it will be eligible for the £30,000 exemption. However, s 402B says there are cases (defined in s 402C) when the payment will be reclassified as general earnings and taxable in full.

A key point is that s 402C states that, if a payment is a redundancy payment or one equal to or less than the amount that would have been payable had a redundancy payment been due, it would still be subject to the £30,000 exemption. A ‘redundancy payment’ is defined as a payment made under the Employment Rights Act 1996. This means that, as now, such a payment enjoys the benefit of the £30,000 exemption but eats into it, reducing the amount available for exemption elsewhere.


Post-employment notice pay

A new concept is also introduced by s 402C, ‘post-employment notice pay’ (PENP). The aim is to find a way to exclude from the £30,000 exemption any amounts which, had the individual’s employment not been terminated, would have been subject to PAYE and National Insurance in full.

For example, when an individual receives a payment in lieu of notice (PILON) the legislation will ensure it is subject to tax irrespective of whether the payment is contractual or is compensatory given in recognition of an employer’s failure to serve proper notice. The draftsman has achieved this aim by stating that, if the PENP is equal to or greater than the termination payment, the whole amount becomes general earnings. If the PENP is less than the termination payment, the PENP becomes general earnings and the remainder benefits from the £30,000 exemption.

Section 402D provides a formula to calculate the PENP. This is done by multiplying basic pay by a fraction equal to the number of days notice the employee is entitled to over 365. Next subtract any sum that has been ‘reclassified’ as general earnings to prevent a double tax charge. If the notice period is expressed in months, the month figure can be used as the numerator and 12 as the denominator.

If the employment has been for less than a year, the basic pay in the calculation can be reduced to the basic pay for that shorter period and the denominator of the fraction reduced to the number of days in that period.

An interesting point is that basic pay is defined as all pay excluding overtime, commission, bonus, termination payments or benefits in kind. Many advisers will be familiar with debates with HMRC under the current rules when the department contends that a termination payment is a payment of a bonus (so general earnings) and not one chargeable under s 401. By excluding bonuses from the calculation of PENP it is likely that this uncertainty will continue in future, albeit over smaller sums, now National Insurance will be charged on all payments in excess of the £30,000 threshold and foreign service exemptions have been abolished.

An additional point to bear in mind is the ‘post-employment notice period’ that is required for the PENP calculation. This is generally the period between the termination and the date on which an individual’s employment could have been terminated legally – when the notice period would have expired. When notice is given by the employee or employer of the termination, this is the point from which the notice period is measured. When notice is not served, the point from which the notice period starts becomes the actual date of termination.


An employee has a termination payment made up of the elements described in Table 1. They have a base salary of £60,000, a notice period of three months and are entitled as a ‘good leaver’ to exercise share options to the value of £5,000. So the employee has a PENP of £15,000 (60,000 x 365/90) (the share options do not count towards the calculation). As shown in Table 2, the taxable sum will increase considerably under the new rules.


Effect of National Insurance

The change to the National Insurance rules will affect employers the most because any payments that are taxable will also be subject to class 1 contributions. The additional 13.8% that will be charged on many elements of large termination packages will need to be factored into the costs of redundancy programmes and employers will have to decide if this will result in smaller discretionary awards.

There is a quirk in that only employers’ class 1 will be charged, not employee’s, and HMRC expects to collect this in real time as it does for all other class 1 contributions rather than through the P11D(b) at the end of the tax year. As a result, employers or payroll providers will have to set up new pay elements that charge class 1 contributions only for the employer.


International element

Finally, there is a big change coming for employers that make termination payments to internationally mobile employees. The current rules allow for some termination payments that would ordinarily be chargeable to tax under s 401 to be excepted from charge when an employee:

  • has spent more than three-quarters of their employment performing duties overseas;
  • has spent at least the previous ten years working overseas; or
  • if employed for more than 20 years, has been overseas for ten of the previous 20 years.

Even if these criteria for full relief are not met, a proportionate reduction for periods of foreign service can be taken after the £30,000 exemption. However, from 6 April 2018 the foreign service relief will be abolished and replaced by a more limited ‘exception in certain cases of non-UK based employment’.

To understand the impact of this change requires going back to basics. Termination payments chargeable under s 401 are defined as ‘specific employment income’ by s 10(3). Unlike general earnings, the special rules regarding the tax residence of employees do not apply to specific employment income so whether an employee is tax resident in the UK when they receive the award is not a relevant factor in determining the tax position.

Instead, to understand whether a payment should be subject to UK tax requires an analysis of its source. For example, if it is made pursuant to the termination of a UK contract (perhaps there is a contract of employment with a UK entity or an entity in the UK is bearing the economic cost of the termination) the payment may be within the scope of UK tax.

The current foreign service relief ensures that when an employee of a UK entity receives a termination payment, only the proportional element that relates to services performed in the UK falls into the UK tax net.

The replacement for foreign service relief (s 412A) is much less widely drawn and will bring into charge the entire termination payment if the employee has had earnings subject to UK tax at any point during their employment. This would apply even if they were never resident or a double taxation treaty absoved them from paying any UK.


Mr A was employed by a UK company but lived and performed his duties overseas. He visited the UK only once during a 20-year employment but performed duties while he was in the UK that were not incidental. He would therefore have been subject to UK tax under s 27 or one of its historic antecedents (although subject to where he came from and the specifics of the case he may not have paid any tax because of the operation of a double tax treaty).

The fact that, under domestic UK legislation, he had been chargeable to tax on his employment income would mean the exception in particular cases of non-UK based employment would not apply and any termination payment he received would be subject to UK tax in full.

It is possible in some cases to avoid double taxation through a treaty, but individuals will nonetheless be in the scope of UK tax and the possibility exists of double withholding tax and the associated cash flow issues for employees.

Some readers may recall that last summer’s consultation on termination payments stated that HMRC planned to replace foreign service relief with a ‘territorial limit in line with other forms of employment income’. The rules as currently drafted seem to go further than this because general earnings can be exempted from UK tax through ‘sourcing’ when employees have earned the money over periods including when they were not UK resident.

It remains to be seen whether HMRC will amend these rules, by charging UK tax only on the proportion of tax years when an individual had some chargeable UK earnings.

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