Post-Employment Notice Pay – are you taxing termination payments correctly?

At the beginning of April 2018, HMRC announced changes to the taxation of termination payments which may, in some circumstances, have a significant impact on the value of those payments. Rather than allowing an employer to make a tax free payment, the new rules effectively introduce a Pay In Lieu of Notice (PILON) clause into all contracts of Employment. A statutory formula calculates how much of a termination payment must be taxed as ‘earning’ – subject to income tax and National Insurance Contributions, even if there is no PILON clause actually contained in the contract of Employment.

Post-Employment Notice Pay clarifies a ‘grey area’

The new rules, which apply in respect of payments or benefits received on or after 6 April 2018 in circumstances where the Employment is also ended on or after 6 April 2018, ensure that an amount equivalent to the income tax and national insurance contributions someone would have paid had they worked out their notice period is still paid, even if the employee does not work out his notice, but receives a termination payment. This will apply to payments made by way of a settlement agreement.

This has been a grey area for UK employment lawyers, so the clarity is welcomed, even if the result of the clarification may mean employees effectively receiving smaller termination payments.

The formula for Post-Employment Notice Pay

To work out the value of PENP – and from there, the amount of tax and NICs payable, employers must use a statutory formula which multiplies an employee’s daily basic pay (BP) by the minimum number of days’ notice (D) that the employee should have worked had the contract not been terminated early. This is then divided by the number of days in the last pay period (P). Amounts paid in connection with termination and taxable as general earnings (excluding accrued holiday pay and any termination bonuses) (T) are deducted to give the PENP, which is then taxable in full.

The formula is as follows: ((BP x D)/P) – T = PENP

For example: A is employed by Business Ltd and earns a salary of £60,000 and has a 3 month notice period. He is given notice on 17th July, but his Employment finishes on 3rd August rather than running until 17th October. He agrees a settlement which includes £15,000 ex gratia, £10,000 for his notice and £1500 in respect of accrued holiday pay.

His monthly salary is £5,000 (BP); the number of days (D) he should have worked to work out 3 months’ notice is 75; and the last pay period (P) would have been June which has 30 days. His holiday pay is not included in T.

The PENP is worked out as follows:

(5,000 x 75)/30 – 0 = £12,500

Where previously A would have received £25,000 tax free in the absence of a PILON clause, he now only receives £12,500 free of tax. The accrued holiday pay is taxable under normal rules.

It’s worth remembering the rule that only the first £30,000 of a termination payment can be ex gratia. Sums above that are taxable.

Calculating ‘basic pay’ for the purposes of PENP

If you or your UK Employment lawyer is calculating a PENP, basic pay is made up of the individual employee’s Employment income, including amounts given up by the employee, but which would have been earnings had they not done so – for example payments given up under a salary sacrifice scheme, but excluding:

- overtime pay, bonuses, commission payments, gratuities and allowances;

- any amounts paid because of the termination of Employment (e.g. retention bonuses);

- the value of benefits in kind;

- various specified amounts treated as earnings (e.g. sickness and disability payments and payments for restrictive covenants);

- amounts which count as Employment income under the Employment-related securities regime (e.g. shares and options); and

- the value of Employment related securities that are general earnings.

The consequences of PENP

Clearly, with the need to pay income tax and national insurance on PENPs, the absence of a contractual PILON clause makes little sense any more. Rather than leave PILON clauses out, employers may look to include these as standard. Solicitors advising on Employment contracts in London and elsewhere in the UK may well now point out the advantage to employers of having a PILON clause: it allows them to be able to end Employment early without having to allow the employee to work out his or her notice – and it’s probably worth having this as an option now that there is no advantage to be gained by not having a PILON clause.

Even if there is a contractual PILON clause in the employment contract, employers need to consider PENP and check there is no discrepancy between the two values.

The other clear issue for employers and employees is the impact that this may have on settlement negotiations and discussions around termination payments. Under these new rules, both employers and employees are going to have to pay more, and the best employment lawyers will take care to remind their clients to factor this in to any discussions.

OTS Solicitors have a team of experienced employment solicitors in London, regularly advising a wide range of employer clients, as well as offering advice on employment law for employees. Whether you are employer or employee, and whatever your issue, we can help with our intelligent, practical employment law support. Book and appointment today by calling 0203 959 9123.