Taxing termination payments
Sarah Bradford, director at Writetax Ltd, explains the new rules regarding taxing termination payments applying from April 2018. She covers termination awards, post-employment notice pay and statutory redundancy pay among other things.
The rules for taxing termination payments changed from 6 April 2018, introducing a new lexicon and potentially bringing more payments within the earnings net. Further changes are in the pipeline in the form of an employer-only (class 1A) national insurance charge on taxable termination payments in excess of the £30,000 threshold, which will apply from 6 April 2019.
The rules which set out how a termination payment (as opposed to a payment of earnings) is to be taxed are found in Ch 3, Pt 6, Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). The new rules were introduced by s5(3), Finance (No. 2) Act 2017 and are found now in ss402A–402E, ITEPA 2003. HMRC guidance on the treatment of relevant termination awards received on or after 6 April 2018 can be found in the Employment Income Manual at EIM13874ff.
When an employee’s employment terminates, for whatever reason, various payments may be made. These may include outstanding salary and wages, holiday pay, redundancy pay (statutory or contractual), payments in lieu of notice (PILONs) and compensation for loss of office.
Payments made on the termination of employment may be taxed in one of two ways – as employment income or under the rules applying to termination payments.
Relevant termination award
A ‘termination award’ comprises payments and other benefits that are received directly or indirectly in consideration or in consequence of, or otherwise in connection with, a termination of a person’s employment (s402A(1), ITEPA 2003, by virtue of s401(1)(a)). The requirement to split a termination award into:
- payments and benefits not benefiting from the threshold treated as earnings; and
- the remainder (if any) – payments and benefits which benefit from the threshold
is imposed by s402A, ITEPA 2003, with s403C setting out the rules for splitting the termination award between the two camps.
The first stage is to identify the ‘relevant termination award’.
A relevant termination award is one that meets all of the following conditions (s402C, ITEPA 2003 and EIM13874):
- the payments or benefits fall within s401(1)(a), ITEPA 2003 (ie, the termination award definition);
- the payments or benefits are received on or after 6 April 2018;
- the employment was ended on or after 6 April 2018;
- the payments or benefits are not statutory redundancy pay or approved contractual payments to the extent that they are exempt under s309, ITEPA 2003; and
- the payments or benefits are not chargeable to tax other than under Ch 3, Pt 6, ITEPA 2003 (payments and benefits on termination of employment).
Splitting the relevant termination award
The relevant termination award is split between an amount treated as employment income and the remainder, if any, which benefits from the £30,000 threshold. The benchmark for determining the amount of the relevant termination award to be treated as earnings is the ‘post-employment notice pay’ (PENP). The allocation is performed in accordance with s403C, ITEPA 2003, which provides that:
- if the PENP in respect of the termination is greater than, or equal to, the total amount of the relevant termination awards in respect of the termination, the whole amount of the relevant termination award is treated as earnings;
- if the PENP in respect of the termination is less than the total amount of the relevant termination awards in respect of the termination, but is not nil, an amount of the relevant termination award equal to the PENP is taxed as earnings and the remainder is taxed as a termination payment benefiting from the £30,000 threshold.
Post-employment notice pay
The PENP is the yardstick against which the relevant termination award is compared. In its guidance, HMRC states that:
'An amount of PENP arises in circumstances where an employee receives no notice, or less notice than they are contractually, or statutorily, entitled to, upon termination of their employment. It represents the amount of basic pay that the employee would have received had they worked the period of notice they were entitled to.'
The statutory rules for working out the PENP are found in s403D, ITEPA 2003, with HMRC guidance available at EIM13880.
The formula for calculating PENP is: ((BP x D) ÷ P) – T.
BP is the employee’s basic pay in respect of the last pay period ending before the ‘trigger date’;
D is the number of days in the post-employment period;
P is the number of calendar days in the last pay period;
T is any payment or benefit received in connection with the termination of the employment which is taxable as earnings under Ch 1, Pt 3, ITEPA 2003 and is not pay in respect of holiday entitlement for a period before the employment ended or a bonus payable for the termination of the employment.
The definition of BP excludes:
- overtime, bonuses, gratuities or allowances;
- amounts received in connection with the termination of the employment;
- amounts taxable under the benefits code (or which would be so taxable but for s64, ITEPA 2003);
- amounts treated as earnings under Pt 3, Ch 12, ITEPA 2003 (payments to employee shareholders and sporting testimonial payments);
- amounts taxed as employment income in respect of securities and securities options (under Pt 7, ITEPA 2003); and
- employment-related securities that are treated as earnings under Ch 1, Pt 3, ITEPA 2003.
Statutory redundancy pay
The ‘trigger date’ is, where notice is given, the day on which notice is given, and where notice is not given, the last day of the employment (s403E, ITEPA 2003).
Statutory redundancy pay and redundancy pay under an approved contractual scheme in place of statutory redundancy pay are exempt from tax under s309, ITEPA 2003, but count towards the £30,000 threshold.
The portion of the relevant termination award, if any, which exceeds PENP is only taxable to the extent that it exceeds £30,000. The first £30,000 is tax-free.
An employee has a salary of £104,000 per annum and is paid four-weekly. The employee is entitled to six weeks’ notice and the employment contract provides for a PILON of £12,000 to be made if the employment is terminated without notice. The employee’s employment is terminated on 10 October 2018. He is 37 and has 12 years’ service. The last payment prior to termination was £8,000 on 4 October 2018 for the four weeks to that date.
He receives a termination package of £62,096 comprising:
- statutory redundancy pay of £6,096 (12 weeks @ £508 per week) (falling within s401(1)(a), ITEPA 2003);
- compensation for loss of office of £40,000 (falling within s401(1)(a), ITEPA 2003);
- a contractual PILON of £6,000 (falling within s62, ITEPA 2003);
- a bonus of £10,000 payable on termination (falling within s62, ITEPA 2003).
The termination award is £46,096 (payments falling within s401(1)(a), being the statutory redundancy pay and the compensation for loss of office.
The relevant termination award is £40,000, being the termination award excluding the statutory redundancy pay.
BP is £8,000, paid on 4 October (in respect of four weeks (28 days)).
T is £6,000, being the contractual PILON taxable under s62. The termination bonus is excluded from the definition of T.
The PENP is:
((£8,000 x 42) ÷ 28) - £6,000 = £6,000.
The relevant termination award taxed as earnings is £6,000 (equal to the PENP).
The balance of £34,000 is taxed as a termination payment benefiting from the £30,000 threshold.
As regards, the availability of the £30,000, £6,096 is used up by the statutory redundancy pay, leaving £23,906 tax-free. The balance of £10,096 (£34,000 - £23,906) is taxable.
The bonus and contractual PILON are taxed as earnings, as is the amount of the relevant termination award equal to the PENP. As a result, the amount taxed as earnings is £22,000 (£10,000 + £6,000 + £6,000).
Therefore the total termination payment of £62,096 is treated as follows:
|Taxable as earnings||16,000|
|PENP taxable as general earnings||6,000|
|Taxable as a termination payment in excess of £30,000 threshold||10,096|
While the premise underpinning the new rules is fairly straightforward, the associated legislation is anything but. HMRC’s guidance helps, but has a tendency to gloss over some of the more complex elements of the rules.
About the author
Sarah Bradford is director at Writetax Ltd and also the editor of Small Business Tax & Finance. She writes widely on tax and NIC issues