New tax rules coming into force on 6 April 2018 will mean that income tax and national insurance contributions (NICs) must be paid on all payments in lieu of notice (PILONs) on termination of employment.

Current rules

Currently the first £30,000 of any PILON enjoys tax-free status provided the employer does not have an express contractual right to make such a payment and has not created an implied right by, for example, a consistent practice of making PILON payments to departing employees. This is because it is treated as damages for breach of contract.

In a few situations, where there is an express contractual right, it has historically been possible to argue that the exemptions still applied. Such arguments have always been difficult as the employer has to breach its own contract.

The new rules

In an attempt to simplify matters, the changes brought in from 6 April 2018 will mean that all PILONs will be taxed as earnings, regardless of whether they are contractual or not. Tax cannot be avoided by failing to pay in lieu.

Under the new rules, employers are required to work out an employee's "post-employment notice pay" (PENP). Essentially this represents the amount of basic pay the employee will not receive because their employment was terminated without full notice being provided. This PENP is taxable as earnings and therefore subject to income tax and NICs even if described as compensation. 

The balance of any termination payment in excess of the PENP can still benefit from being tax free, up to the £30,000 threshold.

Key dates

While the legislation itself suggests that the new rules will apply to all payments made after 5 April 2018, recent guidance from HMRC states that this change in tax status will apply only if both:

  • the termination payment is made after 5 April 2018; and
  • the employment terminated after 5 April 2018.

Therefore the new rules will not apply if the employment terminates before 6 April 2018, even if payment is made on or after 6 April 2018.

Other changes

Other tax changes being brought in from 6 April 2018 include:

  • Foreign service relief is to be scrapped.
  • The tax exemption for payments for injury and disability will no longer apply to injury to feelings (whether on or before termination), save in circumstances where the injury amounts to a psychiatric injury or another recognised medical condition.

How will this affect employers?

The first point to make is that the new rules are expected to increase the sums paid in settling termination claims, with the majority of this extra cost most likely to be met by employers. Employers should implement a review of their post-termination settlement negotiation processes and any template agreements they may use. As has always been the case, HMRC has statutory powers to recover any tax and NICs, plus penalties and interest from employers who incorrectly decide a PILON payment is not taxable.