Finance (No 2) Act 2017 introduced, among other things, new rules when calculating payment in lieu of notice (PILON) for termination payments.
The new rules apply from 6 April 2018 and aim to remove the uncertainty in the treatment of contractual and non-contractual PILON.
The trouble with PILON
HMRC has in the past contested the tax treatment of PILON and there has often been division between HMRC and the employer as to whether the PILON was covered by the termination of employment exemption (up to £30,000) or whether it was to be taxed as earnings.
The new rules
Termination payments or ‘relevant termination awards’ are split into two elements:
- Post-employment notice pay (PENP) which is subject to tax and
- Termination awards subject to the £30,000 tax exemption
The new rules lay out guidelines (and a formula) for calculating each amount.
If the PENP is equal to or more than the total amount of the termination payment, then all will be subject to tax. If the PENP is less than the total amount of the termination payment then only the PENP is subject to tax, with the remainder coming within the £30,000 exemption.
BP is the employee’s basic pay
D is the number of days in the post-employment notice period
P is the number of days in the pay period
T is the total termination payment.
Sounds simple. But, as usual, a bit more explanation needs to be made.
Basic pay (BP)
The definition for basic pay in this context excludes
- Commission, bonus, gratuity or allowance
- Payments connected with the termination
- The cost of any benefits in kind
- Securities, options and some other more complex elements (check the guidance for more detail).
The basic pay amount to be used is the amount paid in the last full pay period that ends before the ‘trigger date’.
The ‘trigger date’ is either the day the notice was given, or, where no notice was given, the last day of employment.
These are the number of days in the post-employment notice period, that is, the time between the last day of employment and the earliest lawful termination date (either contractual or statutory).
Joseph has been employed for one year. His employment is terminated 15 April 2018 with no notice given. Though his employment contract does not provide for a notice period he is entitled to a statutory notice of at least one week. The last day of employment is the day that employment is terminated and the post-employment notice period is seven days.
Mary has an employment contract that stipulates a 30 day minimum notice period. The employer gives notice to Mary on 5 June 2018 that her employment will be terminated 15 June 2018. As Mary is entitled to a notice of 30 days the post-employment notice period (P) is 20 days.
Pay period (P)
This is the number of days in the employee’s last full pay period ending before either
- The last day of employment or
- The day termination notice was given
whichever is the earliest.
If there is no full pay period prior to the above then P is the total number of days worked.
Total termination payment (T)
The total includes any payment or benefit received excluding any post-employment notice pay (anything that has already been taxed as earnings). An example of this would be PILON. There are also a number of other conditions and exclusions which are too complex to be explained here. (For further information see the guidance on Finance (No 2) Act 2017).
Georgio earns £24,000 per annum and his employment contract stipulates a 30 day minimum notice period. The employer gives notice to Georgio on 18 September 2018 that his employment will be terminated 25 September 2018. The total termination payment, including salary is £6,000. His taxable and non-taxable pay elements will be:
= £1,533.33 PENP is taxable and £4,466.67 (£1,533.33 – £6,000) falls within the £30,000 tax exemption.
There are some contracts that will make the calculations more complex, but for the vast majority of cases, the clarity contained within the Finance (No 2) Act 2017 ensures less ambiguity and disagreements between the employer and HMRC.
Bookkeepers and agents should inform employers and clients of the change in rules as this may influence when termination notices and payments are handed out.
Julie Hodgskin is a fellow member of AAT, runs a licensed accounting practice and is a technical materials author for CIPP.