Bulletins | March 13, 2018


New rules come into force on 6 April 2018 that will affect how termination payments are taxed and whether an employee can benefit from the £30,000 tax exemption.

The overall aim is to avoid payments in lieu of notice being treated as part of the tax exemption.

Although brought in under the banner of tax simplification, the new rules are complex and what follows is a summary of the main points only.

There are two key elements to the new scheme.

Post-employment notice pay

First, in order to analyse the tax treatment of termination payments, employers will have to calculate post-employment notice pay, or PENP, which is a new statutory concept.

The PENP is the amount of basic pay that an employee would have earned for the notice period to which they were entitled, less any period of notice worked. For example, if their notice period is three months, their monthly pay £4,000, and they worked one month of the notice period before leaving, their PENP will be £8,000.

Only basic pay is taken into account in calculating the PENP: overtime, bonuses, commission and certain other elements of pay are excluded. However, other benefits may have to be included.

The new legislation contains two formulae for calculating the PENP:

  • a simple formula for cases where the pay period, the minimum notice period and any unexpired period of notice are all whole months; and
  • a more complex formula for other cases, which will probably be the majority.

PENP minus the termination award

Second, the employer must subtract the PENP from the amount of the termination award.

The termination award is another new concept that includes all taxable payments and benefits awarded on termination, with a few exceptions (such as statutory redundancy payments, which are always tax exempt up to £30,000).

If the PENP is equal to or greater than the termination award, the entire termination award will be taxable as earnings.

However, if the PENP is less than the termination award (but not nil), only the amount equal to the PENP will be taxable and the remainder should qualify for the £30,000 tax exemption.

Difficult issues in practice

The relatively complex way in which the legislation is drafted, and the lack of HMRC guidance on it at present, leave some difficult practical issues unresolved:

  • Contractual PILONs: it is unclear whether a taxed contractual PILON should be included in the calculation or not.  One view is that it should be included in order to reduce the PENP to nil, but the legislation does not address this.
  • Dismissal without notice: where an employee is dismissed without notice e.g. for gross misconduct, whether or not they are entitled to notice, and therefore to any PENP, will be a matter of dispute.
  • Deemed notice: if the parties agree that the notice period began on a certain date prior to termination but notice was not actually given, the PENP may still have to include the whole of the notice period that should have been given.
  • Other non-taxable payments: payments, such as employer contributions to pension schemes, that are non-taxable under other parts of the legislation, should not be included in the termination award.
  • Compensation for unfair dismissal: it is not clear under the legislation how this should be treated and whether any of it should be considered as a PENP.
  • Fixed term contracts: the same calculation applies on termination of a fixed term contract, but a notional notice period is used as set out in the legislation.

£30,000 tax free exemption

This will continue to exist for now, but the new legislation contains a power for the government to reduce or increase the tax free band in future.

Settlement agreements

The changes will affect the tax provisions of settlement agreements, which should be reviewed in advance of 6 April.