Frequently asked questions on termination payments
06 January 2021
Our FAQs Inbrief looks at some of the common tax questions that arise on termination of employment.
This inbrief covers:
- Do payments made on termination always qualify for the £30,000 exemption?
- We do not have a PILON clause in our contracts of employment, can we therefore pay out PILONs gross (subject to the £30,000 exemption)?
- Is there NICs on Termination Payments?
- We are proposing to write off an employee’s outstanding loans. Is this ok?
- The employee is requesting that part of their Termination Payment is paid into their registered pension. Is there anything we should be aware of?
Do payments made on termination always qualify for the £30,000 exemption?
No. Just because a payment is made on termination of employment does not mean that it necessarily qualifies sfor the £30,000 exemption. The tax treatment depends on the reason for the payment.
Termination packages may consist of many elements, for example: accrued holiday pay, bonus, payment in lieu of notice (“PILON”), continued private medical insurance and
compensation. You must determine the reason for each element separately.
Generally, the £30,000 exemption applies if the payment in question is compensation for termination of employment (“Termination Payment”). The £30,000 exemption does not apply if there is some other reason for the payment, such as a reward for employment service (earnings), a payment for a new restrictive covenant or a payment on or in anticipation of retirement. Such payments are subject to income tax and NICs in full. In addition, under statutory rules relating to PILONs, the £30,000 tax exemption and NICs exemption may be reduced if any part of the Termination Payment consists of post- employment notice pay (see below).
Occasionally a payment may be made which completely falls outside the scope of income tax and NICs (for example, compensation for injury to feelings due to alleged discriminatory acts prior to termination of the employment).
We do not have a PILON clause in our contracts of employment, can we therefore pay out PILONs gross (subject to the £30,000 exemption)?
Prior to 6 April 2018, some PILONs were not taxable as earnings and benefited dfrom the £30,000 tax exemption (and were not subject to NICs).
This was because the tax treatment of PILONs depended primarily on whether the employer had the contractual right to terminate the employee’s employment by paying a PILON rather than serving notice.
In broad terms, if the employment contract gave the employer the right to terminate by paying PILON (a “PILON” clause”), the PILON was subject to income tax and NICs in full. In contrast, if the employment contract did not allow the employer to terminate the employment by paying a PILON but the employer did so, this “non contractual” PILON would generally have benefited dfrom the income tax and NICs exemption.
If the employee’s employment terminates on or after 6 April 2018 and the employee receives a Termination Payment on or after 6 April 2018 the employer must calculate how much of the Termination Payment (excluding any statutory redundancy pay) is post-employment notice pay, (“PENP”). PENP is, broadly, the basic salary the employee would have received during any unworked period of notice, minus any contractual PILON. PENP is subject to tax and NICs in full.
PENP is calculated using the following formula:
((BP x D)/P) - T
BP = “basic pay” in the pay period which ends prior to the earlier of (i) the date on which notice is given; or (ii) if no notice is given, the termination date (“relevant pay period”). Basic pay excludes benefits bonuses, commission, non-routine allowances, share options/awards but, if the employee participates in a salary sacrifice earrangement, pre-salary sacrifice esalary must be used.
D = the number of calendar days in the unworked period of notice.
P = the number of calendar days in the relevant pay period or, by HMRC concession, where it is to the employee’s advantage P = 30.42 provided that (i) the relevant pay period is a month; (ii) the employee’s salary is paid by 12 equal monthly instalments; and (iii) the post employment notice period is not a number of whole months. Using the concession will be to the employee’s advantage where the relevant pay period has less than 31 days.
T = contractual PILON.
If the PENP is a negative number, it is treated as zero.
A simplified dformula can be used where the employee is paid on a monthly basis; under the employment contract the minimum notice is a number of whole months and the unworked notice period is a number of whole months. In this situation D = the number of whole months in the unworked notice period and P = 1 whole months, (provided the employee is paid on a monthly basis and the unworked notice period is a number of whole months).
Basic pay excludes benefits bonuses, commission, some allowances (see below), share options/awards. However, if the employee participates in a salary sacrifice earrangement, pre-salary sacrifice esalary must be used. HMRC guidance states that an “allowance” is a supplementary payment received by an employee over and above their standard pay but it does not include “any amount which is actually, or in reality reflects san amount which has been, consolidated into an employee’s standard pay”. This suggests that standard allowances such as allowances in lieu of pension contributions should be included in the calculation of basic pay. HMRC has indicated that car allowances should also be included in
basic pay if the employee does not have the option to choose a company car instead of the allowance.
Is there NICs on Termination Payments?
Termination Payments are generally completely exempt from employee NICs even if the termination payment exceeds £30,000.
after 6 April 2020 and all the Termination Payment is paid on or after 6 April 2020, the excess over £30,000 will be subject to Class 1A employer NICs (as well as income tax). This change aligns the employer NICs and income tax treatment of a Termination Payment but increases the cost to an employer of making a Termination Payment of more than £30,000 by up to 13.8% of the excess.
It is worth noting that there is no NICs exemption for protective awards. Protective awards qualify for the £30,000 tax exemption but are subject to employee and employer NICs in full.
We are proposing to write off an employee’s outstanding loans. Is this ok?
Where the Termination Payment is less than £30,000 it is better to increase the Termination Payment to enable the employee to repay the loan and therefore utilise the full exemption.
The employee is requesting that part of their Termination Payment is paid into their registered pension. Is there anything we should be aware of?
Where the employee asks for part of their Termination Payment to be paid into their registered pension as part of the termination arrangements, the pension scheme rules should be checked to ensure that such a contribution can be made. If so, the employer can make the contribution without deducting PAYE income tax or accounting for employer NICs.
However, the employee should consider both the “Annual Allowance” and the “Lifetime Allowance” from a tax perspective and should seek specialist advice on his or her personal circumstances.
Contributions can be made by or on behalf of an employee with full tax relief if, in total, they do not exceed the relevant Annual Allowance for that tax year (for 2020-21 the Annual Allowance is generally £40,000, although there are exceptions - see further below for the exception which applies to high earners). In addition, subject to certain conditions, an employee may be able to carry forward any unused Annual Allowance from the previous three tax years (provided that he or she was at some point during those tax years a member of a registered pension scheme). Individuals are subject to income tax under self-assessment at their marginal rate on contributions in excess of the Annual Allowance.
For those individuals with annual adjusted incomes of more than £240,000, the Annual Allowance is reduced by £1 for every £2 ofincome above £240,000 up to a maximum reduction of £36,000 so that individuals with incomes of £258,000 or more will be entitled to an Annual Allowance of £4,000. In broad terms, annual adjusted income is taxable income from all sources and all pension savings less any pension contributions the individual has personally made. Individuals whose threshold income is £200,000 or less are not subject to the tapered Annual Allowance. Threshold income is taxable income from all sources and excludes employer pension contributions (other than those made under a salary sacrifice eagreement entered into on or after 8 July 2015) and any pension contributions the individual has personally made. An individual affected by the taper may still be entitled to carry forward unused Annual Allowance from the three previous tax years, although the amount carried forward will be limited to the unused tapered Annual Allowance in respect of any tax year in which the taper applies.
In addition to the £30,000 exemption and making a contribution into the employee’s registered pension are there any other tax exemptions which we may be able to use on termination of employment?
c. If the employee suffers from a recognised medical disability or injury which at the date the employee’s employment terminates
prevents the employee from carrying out their job, a payment made solely on account of that disability or injury is exempt from
Specialist advice should be sought if you consider the exemptions in a) to d) above may be relevant.
|Taxable income||Tax rate|
|£0 to £3,125||20%|
|£3,125.01 to £12,500||40%|
We are paying the employee’s legal fees under a term in the compromise agreement. Can we recover the VAT?
No. You can only recover VAT on supplies made to you.
At what rate should employers deduct tax from payments made after the P45 is issued?
The employer is obliged to deduct tax using the 0T code on any payments (including share based payments) made after the P45 is issued which are subject to income tax (irrespective of whether those payments are earnings or Termination Payments which exceed the £30,000 exemption).
For tax year 2020-2021 the application of the 0T code means that for employees in England and Northern Ireland tax is deducted as follows.
The Welsh and Scottish Governments are able to decide the rates of income tax paid by Welsh and Scottish tax payers respectively. For tax year 2020-2021 the rates and bands for Welsh tax payers are as set out in the table above. Different income tax rates apply in Scotland.
|Earning||Employee NICs rate||Employer NICs rate|
|£0 to £169.00||0%||0%|
|£169.01 to £183.00||0%||13.8%|
|£183.01 to £962.00||12%||13.8%|
How are NICs calculated on payments made after termination?
Where a payment which does not qualify for the £30,000 exemption and is therefore subject to NICs (for example, retention bonuses) is made after the P45 is issued, NICs is calculated using the weekly earnings period as set out in the table below. NICs on final lpayments of salary is calculated using the employee’s normal earnings period.
Note there are special rules for directors. For individuals who were directors at the beginning of a tax year, NICs is calculated using an annual earnings period for the remainder of the tax year regardless of when that payment is made.
Weekly earnings period limits (2020-2021).
Should we report the termination payment to HMRC?
The PAYE processes relating to leavers, mean that employers are not required to report leavers separately to HMRC— the employee’s date of leaving is simply included on the FPS. The employer continues to issue Parts 1A and 2 of the P45 to the employee but does not need to send part 1 of the Form P45 to HMRC. If payments are made to the employee after the date of leaving, the employer is required to give the employee a letter showing the date of the payment, the gross amount and the PAYE/NICs deducted.