The new rules, which were originally part of the 2016 Budget but then shelved, now form part the Finance (No. 2) Act 2017, and are designed to align the rules for tax and secondary national insurance contributions (employer (NICs)) although the measure will be introduced into two phases, firstly affecting employees, who will have to pay tax and Class 1 NICs. 

The employment payment notice change goes ahead from 6 April 2018, but employers have been given some relief as employers will only be liable to pay NICs on any part of a termination payment they make to their employees that exceeds the £30,000 threshold from 6 April 2019. This measure was initially designed to come into force on 6 April 2018 but the government backtracked and delayed the employer tax element by a year (confirmed in HMRC update issued 9 November 2017, although the detailed HMRC guidance has not been updated as yet).

In its policy paper published in autumn 2017, HMRC said it is anticipated that this will be collected in real-time, as part of the employer’s standard weekly or monthly payroll returns and remittances.

In addition, the measure clarifies the scope of the exemption for termination payments through a number of changes. All payments in lieu of notice (PILONs) will be both taxable and subject to Class 1 NICs.

The legislation requires the employer to identify the amount of basic pay that the employee would have received if they had worked their notice period, even if the employee leaves the employment part way through their notice period. The amount will be treated as earnings and will not be subject to the £30,000 income tax exemption.

All other termination payments will be included within the scope of the £30,000 termination payments exemption.

The measure also makes changes to certain exemptions in the termination payments legislation. It removes foreign service relief, with an exemption for seafarers, and clarifies that the exemption for injury does not apply in cases of injured feelings.

HMRC says this measure is intended to bring fairness and clarity to the taxation of termination payments by making it clear that all PILONs, rather than just contractual PILONs, are taxable earnings. All employees will pay tax and Class 1 NICs on the amount of basic pay that they would have received if they had worked their notice in full, even if they are not paid a contractual PILON.

This means the tax and NICs' consequences are the same for everyone and it is no longer dependent on how the employment contract is drafted or whether payments are structured in some other form, such as damages.

The existing £30,000 income tax exemption will be retained and employees will continue to benefit from an unlimited employee NICs exemption for payments associated with the termination of employment. This will ensure that those who lose their job will be supported through the tax system.

The legislation splits an employee’s termination payment into two types of payment: payments that can still benefit from the £30,000 threshold and those that cannot. The legislation works by first identifying any payments that should be treated as earnings and any remainder is then subject to the £30,000 exemption.

According to the impact note, HMRC expects the changes to provide over £400m of additional tax annually from 2018/19, rising to £485m by 2020/21.

HMRC guidance, Income Tax and National Insurance contributions: treatment of termination payments

Further reading

Termination payments - tax rule change from April 2018 (note this guidance was last updated on 9 November 2017)

Report by Pat Sweet, Sara White