Termination payments are often made to employees when the termination of their employment is governed by a settlement agreement. New rules affecting the taxation of termination payments came into effect on 6 April 2018.
What are the changes?
There has been a change to the taxation of 'payments in lieu of notice' (PILONs), which are commonly part of any overall settlement.
Where employment terminates on or after 6 April 2018, there will now be no distinction between contractual and non-contractual PILONs. Both will now be subject to deductions for tax and national insurance. Previously, employees could generally receive a PILON free from tax and National Insurance if the employer had no contractual right to terminate employment early and make a payment in lieu of notice (or the balance of notice).
The change means that if the overall settlement terms include a payment in lieu of all or part of notice, or if the termination payment is made up in part by any such sums, these elements will always be taxable.
Why is it important?
If termination payments are not taxed correctly HMRC can recover unpaid tax and National Insurance Contributions (NICs). Penalties and interest can also be imposed.
In addition to employee NICs, employers have to pay employer NICs on payments constituting earnings from employment. This can add to the overall costs of settlement and should be borne in mind when negotiating or agreeing terms.
If an employer fails to correctly deduct tax or NICs (or both) from any termination payments, the employer is usually liable for it, plus any applicable interest or penalties. The employee would ordinarily be entitled to a tax credit for the tax that should have been deducted.
Employer and employee must therefore ensure that any termination payment is legitimately structured to both minimise the tax liability and ensure that no future tax liability will arise. Any settlement agreement must also clearly and expressly state who shall ultimately be liable for any additional tax, NICS and the like.
Given that the taxation of termination payments has become a more complex matter it is important to take appropriate advice before negotiating and concluding terms.
