TAX AND NATIONAL INSURANCE TREATMENT OF TERMINATION PAYMENTS: GOVERNMENT RESPONSE AND CONSULTATION ON DRAFT REGULATIONS

As reported in Advisory Bulletin 628, the Government issued a consultation paper on the tax and national insurance contributions (NICs) treatment of termination payments in July 2015. It has now published a response to the consultation and has also issued a technical consultation on draft regulations, to implement its plans.

Summary of response

Following the consultation the Government has decided that it will:

The LGA will be responding to the consultation and details of the consultation and how to take part are on pages 4 to 7 of this document. We would welcome views from authorities and comments should be sent to [email protected] by 29 September.

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Continue to support individuals when they lose their job by ensuring that: o the first £30,000 of a termination payment remains exempt from income tax; and o any payment paid to any employee that relates solely to the termination of the employment continues to have an unlimited employee NICs exemption.

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Make the tax and NICs treatment of all postemployment payments consistent. Any payment that the employee would have received if they had worked their notice period, even if the employee is asked to leave immediately or part way through their notice period, will be taxed and subject to Class 1 NICs. Amongst other things, this will remove the confusion about the different rules for payments in lieu of notice (PILONs) by making all PILONs taxable and subject to Class 1 1

NICs. 

Make employer NICs payable on payments above £30,000 (which are currently only subject to income tax).

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Clarify that the exemption for injury does not apply in cases of injured feelings.

The changes are expected to come into force in April 2018. PILONs, contractual and non-contractual payments

In its consultation the Government had asked for views on removing the distinction between the different tax treatment of contractual and noncontractual termination payments, including PILONs, and action that could be taken to prevent manipulation of the rules. The majority of respondents to the consultation agreed that the distinction between the treatment of pay in lieu of notice payments made under a PILON clause i.e. a contractual payment which is taxable, and a pay in lieu of notice payment which is made in response to a breach of contract i.e. failure to give notice, which is generally speaking not taxable, is confusing (as this sentence illustrates!). The Government is therefore removing this distinction and all pay in lieu of notice payments will be taxable and subject to NICs. The Government had also considered removing the distinction between contractual and non-contractual termination payments. However, there was less support for this and the Government is to retain this general distinction. However, it will ensure that only payments directly related to the termination of employment may use the exemption. Any payments that would have been made in the absence of the termination will be taxable and subject to Class 1 NICs. In order to determine which post-employment payments (or proportion of a payment) will be subject to the exemption, employers will need to refer (as they do now) to the employee’s underlying employment contract and other terms and conditions. Any payment that covers part of the existing contractual entitlement, including the notice period 2

even if the employee does not work it, will be taxed and subject to Class 1 NICs as earnings. Anything that is non-contractual will be the termination payment which will be taxed on any amount that exceeds the £30,000 threshold. Another measure which the Government is to introduce in an attempt to remove the incentive to manipulate the rules is to align employer NICs and income tax treatment. Therefore, where a termination payment is made in excess of £30,000 and is therefore subject to income tax, the employer will, from April 2018, be liable to pay employer NICs on the excess. Employees however will not have to pay any NICs on termination payments, even if the amount is in excess of £30,000. £30,000 tax threshold

The consultation had considered whether to change the level of the tax threshold after which income tax is due on a termination payment, including whether or not the amount should be reduced and linked to length of service. However, the Government has decided not to change the threshold as the majority of respondents did not support this. It will therefore remain at £30,000.

Exemptions

There are various exemptions, reliefs and reductions that apply to termination payments in addition to the £30,000 threshold. For these exemptions to apply, the payment must be connected to the termination itself and not be contractual or salary. If the conditions of the exemption are met then there is no income tax liability even on payments over £30,000. These include payments made:        

because of the death, disability or injury of the employee; under a tax exempt pensions scheme; to a registered pension scheme; for liabilities and indemnity insurance; to HM Armed Forces; by a foreign government; where the employee has a certain type of foreign service; or in respect of certain legal costs. 3

The consultation asked if these exemptions should remain and whether caps for certain exemptions should be put in place. In general, most respondents thought that the exemptions should remain, and in accordance with this the Government has decided that there will be little change in this area. One change though that may impact on local authorities is that the Government will clarify that the exemption for injury does not cover injury to feelings (e.g. for sex discrimination). In order for the exemption to apply there must be an injury or disability of a physical or psychological nature that is sufficient to cause the employee to be unable to perform his or her job properly. The first consultation also asked for views on introducing exemptions for awards for payments connected to loss of earnings in discrimination cases and unfair and wrongful dismissal compensation. However, in its response the Government states that no new exemptions will be introduced and that the £30,000 threshold already provides significant support. In summary therefore:

CONSULTATION ON DRAFT LEGISLATION

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all PILONs will be subject to tax and NICs as earnings, irrespective of whether they are made pursuant to a PILON clause;

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all other post-employment payments which would have been treated as general earnings if the employee had worked their notice period will be subject to tax and NICs; and

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payments relating directly to the termination of the employment will have a £30,000 income tax and employer NICs exemption. There will be continue to be an unlimited employee NICs exemption on termination payments.

The consultation on the legislation to implement the Government’s plans sets out the proposed draft legislation on the income tax aspects of the new termination payment rules (NICs legislation will be published in draft in the autumn). It is therefore of a complex technical nature and to assist with 4

interpreting how the legislation is intended to work there are some examples to show how the changes are meant to work in practice. There are then six questions in relation to the draft legislation (see page 20 of the consultation document under “Explanation of the draft legislation”). Authorities may find it useful to review the examples and we have set out below the consultation questions with some LGA comments. Consultation questions with LGA comments

Question 1. Is it appropriate to use a period of 12 weeks to calculate the cash and benefits element of the ‘post-employment notice income’? Are there any circumstances where this could lead to unfair outcomes? LGA comments: The proposed amendments to the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) will treat part of a termination payment as pay in respect of any notice period that has not been worked. In accordance with the principles proposed in the Government’s response, this part of the payment will be subject to tax and national insurance. The amount of the termination payment deemed to be notice pay received is calculated by finding the average daily rate of earnings in the preceding 12 weeks before notice was given, or if no notice is given, before the termination took effect. This daily rate is then multiplied by the number of days of the notice period that the employee did not work. The amount calculated cannot benefit from the £30,000 tax-exempt threshold. In its consultation, the Government explains that it is proposing to use a 12-week reference period to cover employments which have irregular levels of income. In general this would be an acceptable method of calculating the amount of pay that should be treated as notice pay. The use of 12 weeks as a reference period is a familiar tool in employment law. However, there may be occasions where this calculation would result in a higher or lower figure than the actual notice pay the employee receives. For example, there may be cases where a shift worker has a set pattern of work for the next few months, which the employer uses to calculate the amount of notice pay the employee is entitled to. If this was lower than the figure that results from the ITEPA calculation they 5

would have to pay more tax and national insurance than should have been the case. We would be interested to hear from authorities whether or not they have established methods of calculating notice pay that would result in similar disparities between sums treated as notice pay as set out above. Although the consultation paper does say that there is some detail that has not been included in the draft legislation, we note that the current draft does not seem to take into account the fact that there are various issues which may need to be addressed. For example, the treatment of employees where they have been receiving less than full pay prior to termination but are entitled to full pay during the notice period under sections 88 and 89 of the Employment Rights Act 1996 (which the employer may include in a termination payment). The Government may also want to address how to treat those employees whose pay is based on an annual average, for example, term-time only employees. As there is the potential for a discrepancy to arise here between the figure calculated under ITEPA and the payment the employees may actually receive depending on the approach the employer takes. LGA comments

Question 2. We have given bonus a wide meaning in this legislation. Is this appropriate? LGA comments: Section 402D(10) provides that ‘“bonus” includes commission, incentive and anything similar.’ We would consider that a wide definition of bonus is appropriate given the Government’s policy. Question 3. We have used a wide interpretation of ‘arrangements’ in the anti-avoidance provision at s402D(9). Is this sufficient? LGA comments: see comments on question 4 below. Question 4. We are considering what other antiavoidance provisions may be needed in the legislation. Are there other aspects of the policy might require anti-avoidance safeguards and how 6

should these be targeted? LGA comments: We would support the Government’s efforts to ensure appropriate anti-avoidance provisions. We would welcome any comments and suggestions authorities may have. Question 5. To comply with this draft legislation, are there any additional pieces of information that employers and payroll managers would need to identify beyond what they already have available? LGA comments: We would welcome views from authorities. Question 6. Are there other aspects of the termination payments legislation that the government should address while we have this opportunity? LGA comments: We would welcome views from authorities. Responding to the consultation

We will be submitting a response and would welcome any views. Please send your comments to [email protected] by 29 September. The deadline for responses to the consultation direct to the Government is 5 October 2016. Responses should be sent by email to [email protected] or by post to: Employment Income Policy Team Room 1E/08 100 Parliament Street London SW1A 2BQ

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