Ensure you understand how to tax notice pay when it is paid in lieu following recent changes to the law in this area

This April saw the most significant change to the taxation of termination payments in many years. The intention of the change is to tax payments for unworked notice as though the notice had been worked, though the details of the implementation are inevitably more complicated than that. 

The main consequence of the change relates to employments that are terminated without full notice, and therefore in breach of contract. Assuming that a contact contains no PILON clause, any settlement of the employee’s claim for that breach would previously most likely have been taxed only to the extent it exceeded £30,000. Under the new rules, the part of that settlement payment taken to compensate the employee for insufficient notice is subject to tax and NICs (any compensatory amount beyond this is taxed under the old rules, potentially with the benefit of the £30,000 tax-free amount). 

The new rules contain detailed provisions for determining how much of any settlement payment is to be taken as compensating the employee for insufficient notice. In particular, those provisions start with a notional “basic pay” that takes a specific reference period, deducts commissions and bonuses, and adds back any amounts that are normally deducted under salary sacrifice arrangements. So it is not enough to just start with the employee’s last gross pay. Also, there are detailed (and not entirely intuitive) provisions for computing the amount of notice that the employee did not work, and a detailed fact find will always be necessary to carry out the calculation. 

Because the provisions are complex, there is a certain amount of misinformation in circulation. For example, although people may think otherwise, the new rules do apply equally to employees whose contracts contain a PILON clause. Although in practice the new rules are unlikely to significantly prejudice an employee in that position, the employer nevertheless needs to carry out the detailed calculation and withhold any additional PAYE that results. 

The new rules represent a significant risk for employers to manage, given that any errors (even if minor) may result in substantial PAYE penalties. We are able to provide training for employers on how to operate the new rules, and of course we are also able to assist you with specific issues when they arise.

At the same time as the change mentioned above, Foreign Service relief for termination payments was also withdrawn for employees who are resident in the UK in the last year of their employment. In some scenarios there may be scope for departing employees to take steps to substantially improve their tax position, but timely tax advice will be essential.