New rules came into force on 6 April 2018 which changed the taxation of termination payments where both employment ends and the termination payment is received on or after that date. The new rules are designed to simplify the taxation of termination payments, but in reality, the rules are complex and are often leading to increased difficulty calculating the correct tax on termination.
What is the new tax concept getting at?
In the past, employers could potentially pay an amount that represented notice pay tax free up to £30,000, provided there was no contractual right to a payment in lieu of notice (PILON). Where there was a PILON or what was called an auto-PILON, tax had to be paid.
The main aim of the new rules is to remove this grey area by effectively treating all employment contracts as containing a PILON clause. This means that employees will be subject to income tax and employee’s and employer’s NICs on an amount which represents their outstanding notice.
The new rules centre around the new concept of ‘post-employment notice pay’ or ‘PENP.’
It is important for employers to understand the new rules
Clearly employers need to understand how the PENP calculation operates in practice to ensure payments are taxed correctly under the new regime. It is also important to ensure that the additional cost to employer and employees (which is likely in many cases) is factored into discussions with employees who leave without working their notice period out in full.
The simple aim of the new rules (to calculate the part of the termination payment that represents notice and tax it as earnings) has been met through a potentially complex legislative formula that throws up quirks in practice.
How do the PENP rules operate?
Under the new rules, a statutory formula must be applied:
(BP x D)/P) – T = PENP
The starting point is “BP” - an employee’s daily basic pay in the last regular pay period before the “trigger date”. The trigger date is when notice is given or the last day of employment if no notice is given. Basic pay refers to employment income excluding overtime pay, bonuses, commission payments and gratuities (among other things) but including amounts an employee would have been entitled to had they not given them up under a salary sacrifice arrangement.
Basic daily pay is then multiplied by the number of days in the “post-employment notice period” - the minimum notice period the employer is required to give starting from the “trigger date”.
Finally, amounts paid in connection with termination that are taxed as general earnings are removed from the PENP calculation in order to prevent double taxation, unless that is they represent accrued holiday pay or a bonus payment – this is the deduction “T” in the calculation. T is generally going to represent any money paid under a contractual PILON and which has therefore been taxed in the usual way.
The formula can be simplified using months rather than days where an employee is paid monthly with a minimum notice period and a post-employment notice period that can be expressed as a whole number of months.
Some key practical results of the formula are the following:
- If an employee has worked their whole notice period (with salary paid and fully taxed), the PENP will be nil and no further tax will need to be deducted. Any termination payment will be unaffected.
- If a contractual PILON has been paid, the PENP may be NIL, but a calculation should still be carried out as, in particular, if there is a salary sacrifice arrangement in place, the PILON amount may be less than the PENP amount and therefore additional tax will need to be paid.
- Where no notice or partial notice has been worked and there is no contractual PILON payment, a PENP calculation will need to be carried out and tax deducted from this amount. This may mean a renegotiation of the overall termination package.
This is a short note summarising the main parts of the PENP and its calculation. It does not cover all circumstances in which the calculation throws up anomalies, and we would recommend seeking legal advice on the facts of any given case.
In the past, employers sometimes elected to have no contractual PILON in their employment contracts because of the tax advantages. The flip side of this decision was that the employer would be in breach of contract if they dismissed without notice and paid a PILON, risking the argument that any restrictive covenants would fall away.
Employers may now wish to consider, given the tax saving has gone, incorporating a PILON clause into standard employment terms, providing flexibility to terminate an employment contract without being in breach of contract thereby not jeopardising any restrictive covenants.