Important measures introduced at the start of the 2018-19 tax year concern termination payments, salary sacrifice and workplace pension contributions.
Three key changes to the tax treatment of payments made on termination of employment apply from 6 April 2018 and need to be considered by employers and those advising employees when negotiating settlement agreements.
Payments in lieu of notice
Often when employment is terminated an employee will leave the business without serving their notice. In those circumstances a payment in lieu of notice (PILON) will usually be made to compensate the employee for the pay they would have earned had they worked through their notice period. Before April, PILONs provided for in a contract of employment were subject to income tax and National Insurance deductions, but non-contractual PILONs generally fell within the more beneficial regime under section 401 ITEPA 2003 (including the £30,000 tax free exemption).
The distinction between contractual and non-contractual PILONs has been largely removed. As a result, income tax and both employer's and employee's National Insurance contributions are due on payments equating to notice pay made on or after 6 April 2018 when the employment also ended on or after that date. Such payments cannot fall within the £30,000 tax free exemption for ex gratia termination awards.
This is a major change and expectations will need to be managed, both in the business and also those of the departing employee who may expect to receive a gross payment based on previous practice.
Historically, some employers opted not to include a PILON clause in their standard contracts to benefit from the tax advantage, even though this prevented them relying on restrictive covenants if they wanted to terminate summarily and pay in lieu of notice. This rationale has fallen away and employers should now include a PILON clause in their standard employment contracts.
Although in headline terms the new position is simpler, the legislation is complex and there are a few traps to watch out for.
- If there is no PILON clause, all sums equivalent to the 'basic pay' that the employee would have received had they worked their notice will be taxed as earnings. These are, broadly, all pay excluding overtime, commission, bonuses, termination payments or benefits in kind. That differs from the situation when a PILON is included in the contract because this may provide for the employee to receive other benefits in lieu of notice, in addition to basic pay. It is not therefore as simple as all benefits for the notice period being taxable as earnings.
- 'Basic pay' also includes salary that would have been received had it not been sacrificed for a benefit in kind. This one is easy for employers to overlook, particularly if they have flexible benefits schemes in place.
- When a fixed-term contract is terminated and does not contain provision for what happens on an early termination, the payment of salary for the remainder of the contract will no longer be treated as compensation subject to the £30,000 tax exemption. The basic pay due between the early termination date and the expiry of the term will be treated as a PILON and so will be fully taxable as earnings and subject to National Insurance.
Foreign service relief
Previously, when an employee had been working and resident overseas, at least a proportion of any termination payment, and potentially all of it, would normally be exempt from income tax, regardless of their residence at the date of payment. From April, however, no relief will apply if the employee is UK-resident at any point in the tax year of termination.
This is a major change and could have a big impact on the tax position of employees returning to the UK after termination. It is therefore crucial that advice is sought at an early stage to understand how this change may affect particular employees, whether it is feasible to structure around it and, if not, ensure the increased costs are properly factored in.
Injury to feelings
In recent years there has been some doubt over whether payments made in discrimination cases for injury to feelings may be exempt from tax. This is even when the discrimination is connected with termination of employment, relying on the exemption for payments made on account of disability.
It has been put beyond doubt that payments for injury to feelings cannot be exempted in these circumstances unless the emotional damage amounts to a recognised psychiatric or other medical condition, and satisfy the other usual requirements for such payments. This emphasises the importance for employers to consider whether, and to what extent, the payment can reasonably be said to relate to pre-termination discrimination and treat it accordingly.
As a result of these changes employers need to have in place updated policies and systems to deal with termination of employment that are understood by both the business and human resources teams. These will ensure that the financial impact is properly quantified in each case and factored into settlement negotiations. Failure to do so is likely to prove expensive if the employer has to meet the increased cost of promises made to employees in 'informal' early discussions. Delivering promises of net payments can prove doubly costly since payments to 'make good' the extra tax exposure will need to be grossed up themselves.
The drafting of settlement agreements may need to be revisited to ensure that they take account of the new regime and contain the necessary powers for the employer to deduct tax and National Insurance when it is obliged to do so.
The optional remuneration arrangements (OpRA) legislation, which has been in force since 6 April 2017, will catch many arrangements for the first time from this April. The rules apply when an employee receives a benefit in lieu of earnings, including arrangements under flexible benefits, trade up or down arrangements, cash alternatives and salary sacrifice or bonus waivers. They do not apply to registered pension arrangements, pensions advice, employer-supported childcare, cycle-to-work and ultra-low emission cars. The regime is intended to remove the tax advantages that arose when some non-cash benefits were provided as part of a salary sacrifice arrangement.
In general terms, under OpRA the value of benefits provided is deemed to be the higher of the amount of earnings foregone, less any made good by the employee, and the taxable value of the benefit that would otherwise apply.
Although the rules came into force last year, many taxpayers were not affected until this April. This is because of the grandfathering provisions that allowed the old rules to apply to an arrangement entered into before April 2017 until the earlier of:
● the arrangement ending or being varied; or
● 6 April 2018 (6 April 2021 for cars, accommodation and school fees).
A renewal of a grandfathered OpRA will not itself be grandfathered but will come within the scope of the new rules from the date of the renewal. This is likely to include automatic renewals.
The OpRA provisions are much wider than traditional salary sacrifice because they also affect any arrangement under which the employee can choose between cash and a benefit.
Employers should have updated their systems and procedures to ensure the correct benefit in kind amounts are captured, whether for payroll or P11D purposes. Otherwise, businesses risk underdeducting tax and incurring HMRC penalties.
Businesses should already have considered the impact of the changes on their staff to ensure that the positive effect of reward schemes is not undermined by unexpected tax charges. This is especially relevant given that the taxable sum on the benefit will often be significantly increased from what had been the case historically.
For instance, if an employee in their contract is offered a cash alternative to a company car of £8,000 a year or a particular company car on which the benefit in kind is £4,000 for the tax year, under the OpRA rules they will be taxed on the greater of £8,000 (the cash allowance) or £4,000 (the benefit in kind on the company car they are provided with). Under the old regime the employee would have been taxed on the £4,000 if they chose to take the car, so it represents a significant tax increase if they exercise the option to take the car rather than the cash. Contrast the position if no option is offered and the only entitlement is to the car, in which case the charge would remain at £4,000.
The minimum employee and employer contributions to a workplace pension increased from this April. Given the expected fivefold increase in the cost to employers of pension contributions for employees, businesses should consider introducing salary sacrifice arrangements for the employee element to be paid directly into a pension scheme. This would have the benefit of generating a saving of employer's National Insurance, which could be substantial after minimum employee contributions increase to 5% from April 2019.
In recent years, HMRC has been focusing on payroll taxes and conducting employer compliance reviews. This is paying off: in 2016-17 it recovered an additional £819m from investigations into payroll taxes, up 16% from the amount collected in 2015-16. With the initiative proving lucrative, we can expect the focus on employer compliance to continue and these new rules are likely to be areas HMRC will be scrutinising.
Future changes in law are also probable. We already know that from April 2019 the government intends to apply National Insurance to ex gratia termination payments of more than £30,000 and on sporting testimonials of more than the £100,000 lifetime exemption. Further, Good Work: the Taylor review of modern working practices has highlighted some of the discrepancies in employment and tax treatment for those working in the gig economy, and we may see legislative changes in this area.
There are likely to be radical changes to the tax treatment of intermediaries. The government has issued a consultation document on a proposal to extend its off-payroll working legislation from the public to the private sector, making those engaging workers through personal service companies liable to account for National Insurance and tax. This would result in a raft of additional responsibilities and administrative pressures for much of the private sector.
Finally, the new corporate criminal offence of failure to prevent the facilitation of tax evasion came into force on 30 September 2017. This makes businesses criminally liable for the acts of their employees or other associated persons if they do not have in place reasonable prevention procedures. Employment tax compliance is an area where many businesses will be at risk and they need to consider carefully how they can manage it.
Chris Thomas and James Wood are employment tax experts at Pinsent Masons, the law firm behind Out-Law.com. This is based on an article which was published in Taxation on 17 May 2018