Tax on Employment Settlement Agreement Payments to Change

15 September 2016

HMRC has published draft law which intends to make changes to the tax to be paid on termination payments in employment Settlement Agreements. The changes are intended to be in place from April 2018.

The aim of the new rules are to simplify a complex and often confusing tax system.

The Current Position in England & Wales

For many years there has been a rule that the first £30,000 paid to an employee when their employment is ended will be paid without deductions for income tax and national insurance if this payment is not a contractual entitlement. (There are a few exceptions that fall outside the scope of this update article). The £30,000 works to ensure the full amount of any statutory redundancy pay will not be taxable.

The difficulty has always been in relation to notice pay. Generally there are three situations which may arise when an employee’s employment is to end:

1) The employee works their notice period and receives their normal salary with the normal deductions.

2) The employee is put on garden leave for the notice period so remains an employee but is asked not to attend work. The employee receives their normal salary with the normal deductions.

3) The employer may end the employee’s employment immediately and instead pay them their notice pay in a lump sum (pay in lieu of notice).

It is in scenario 3 that confusion can arise.

If there is a term in the employment contract that allows the employer to pay in lieu of notice (PILON) then the lump sum for notice pay is taxable.

Alternatively, if there is no right in the contract of employment to pay an employee pay in lieu of notice, then technically the employer is in breach of contract by not allowing the employee to work their notice period. In these circumstances there is an argument the payment is compensation for the breach of contract rather than actual notice pay and can therefore be paid free of deductions of income tax and national insurance contributions.

When there is no written contract of employment the situation is more complicated. There have been instances where the employer routinely pays in lieu of notice and therefore the right to do so becomes an implied term of the contract. This would mean the pay in lieu of notice would be taxable.

HMRC’s Intended Changes at a Glance

The main changes that are intended are:

• To make all payments in lieu of notice taxable, even if they are non-contractual.

• To require payment of employer National Insurance Contributions (NIC) on sums over £30,000 (not currently payable) as well as income tax (currently payable over £30,000). Such payment will continue to remain exempt from employee’s NIC.

• Ensuring payments for injury to feelings (this relates to situations involving workplace discrimination) are subject to tax. This provides clarity to conflicting decisions that have recently been made by Employment Tribunals. The current tax exemption for death, disability and personal injury will be retained.

• To introduce a two year condition period before people are eligible for any tax free payment (reflecting the qualifying period for unfair dismissal).

• The draft legislation also gives HM Government the power to vary the current £30,000 threshold at some point in the future although the figure has not been varied for a long time. The Government recently reviewed the threshold figure and found it to be at an appropriate level so there is no indication that the Government intends to exercise this power in the near future.

Although the changes would make for a clearer position regarding tax, it is going to mean more employees end up paying tax on sums received in a Settlement Agreement. This will no doubt impact some employee’s decision as to whether to accept a Settlement Agreement offer or to make a claim in the Employment Tribunal.

In our experience PILON clauses (which makes the PILON payment liable to tax) have become more popular so the impact on an employee may not be as large as anticipated. It is unlikely that the level of termination payments will drop as a result of this legislation. There will be an additional cost to employers who will probably have to increase the ex-gratia payment in some cases to incentivise employees to take a Settlement Agreement to balance out the loss of tax benefits around PILON.

We can help you by providing legal advice on your situation and the likely compensation that would be awarded if your claim were to be successful at an Employment Tribunal.

The actual wording of the draft law is open for comment and discussion until 5 October this year so there may yet be further changes.

There are many points to consider about Settlement Agreements, for more information see How Our Settlement Agreement Solicitors Can Help You.

At Co-op Legal Services our team of Employment Law Solicitors are always up to date with changes in the law and are able to answer questions you may have. If you are unsure of the implications of the above information on your circumstances, or in fact the current position, please do not hesitate in contacting us for prompt legal advice.

More articles