New taxation rules for termination payments made on or after 6 April 2018

The new tax regime requires employers to split a termination (or compensation) payment between amounts treated as earnings and amounts benefiting from the £30,000 tax exemption.

This means in practice, employers must treat a slice of the termination payment, which reflects the basic pay for any part of a notice period that is not served, as earnings and this slice is then subject to income tax and deductions of employer and employee National Insurance Contributions. However, if pay in lieu of notice is paid and taxed then no split is required (for most cases).

This taxable slice is called the Post Employment Notice Pay (‘PEMP’). The PEMP will be equal to the amount of basic pay the employee will not receive because his or her employment was terminated without full or proper notice being given. This change is designed to ensure that the equivalent of an employee’s notice pay, which is included in a termination or compensation payment, will be taxed and subject to National Insurance Contributions. This new regime applies regardless whether or not there’s a payment in lieu of notice clause in the employee’s contract of employment.

The PEMP will be calculated by applying a formula to the total amount of the termination payment, or benefits paid in connection with the termination of the employee’s employment. The formula and related rules are not the easiest to get to grips with and the HMRC Employment Income Manual is currently still being updated but will be published “in due course”. We will publish a more detailed Briefing Note on how to calculate the PEMP as soon as possible.

The balance of the termination payment or benefit, which isn’t a PEMP, will be taxable as employment income if it exceeds £30,000 and will be treated in the same way as other payments and benefits that are currently taxable. In practice, the employee will be able to still have the benefit of £30,000 tax-free compensation but if any element of that compensation includes the equivalent of unpaid and taxed notice pay then the PEMP will apply and be taxed.

HMRC has confirmed that PEMP calculations do not apply to statutory or non-statutory redundancy payments. These payments are always taxable as specific employment income and are subject to the £30,000 exemption when appropriate.

At the moment it is not clear if after a summary dismissal – say, without notice for gross misconduct – the parties subsequently reach terms of settlement, it is not clear whether it will be necessary to carry out the PEMP calculation in respect of any settlement payment. We hope this question will be answered in the updated HMRC guidance to be published shortly. 

Needless to say, we will ensure our advice to clients will deal with this new regime for all settlement agreements that relate to dismissals that take place on or after 6 April 2018. The above changes require settlement agreements to be updated and we have already ensured our precedent settlement agreements reflect them.

For many employers this new regime will not be a real problem because the employee works in full the notice period or a payment in lieu is paid under the terms of a contractual pay in lieu of notice (PILON) clause. However, given the formula used for calculating the value of the PEMP, care must be taken as in some cases additional tax and NICs will be payable from a compensation payment.

Many employers pay and tax notice pay under PILONs as this ensures the restrictive covenants in the contract of employment survive as enforceable. If an employer dismisses in breach of contract by not making a required PILON the restrictive covenants fall away as unenforceable.