It has now been more than a year since HMRC introduced a change to the way that termination payments are taxed. Last month, we conducted a survey amongst HR practitioners to assess the level of awareness of the change. Out of a total of 33 respondents, 79% were aware of the change. However, 55% were not aware of the Post Employment Notice Pay (PENP) formula which is a key part of the change. This lack of awareness of the PENP formula is not surprising. Although the change itself is fairly straightforward in principle, the formula is a rather cumbersome calculation and can produce some odd results.
So what has changed? Prior to 6th April 2018, an employer could include a payment in lieu of notice (PILON) as a tax free amount (subject to the maximum amount of £30,000) to be paid as part of a termination award, if the employment contract had no provision for such a payment to be made. However, from 6th April 2018, if an employer makes a relevant termination award (i.e. any payment or benefit which compensates an employee for the termination of employment, excluding statutory redundancy pay) and the employee does not work any of their notice period or only works part of it, it is necessary to apply the PENP formula to calculate the amount due for the unworked notice. The amount calculated by the PENP formula becomes subject to tax and NI.
The PENP formula is as follows:
((BP × D) ÷ P) – T
‘BP’ is the employee’s basic pay in respect of the last pay period of the employment ending before the “trigger date” (i.e. the day notice is given or where no notice is given, the last day of the employment).
‘D’ is the number of calendar days in the post-employment notice period (i.e. unworked notice period).
‘P’ is the number of calendar days in the employee’s last pay period.
‘T’ is any payment or benefit received in connection with the termination of an individual’s employment which is already subject to income tax but specifically excluding holiday pay and bonuses payable for termination of the employment.
If the amount given by the formula is negative then the amount of PENP is taken to be nil.
If the amount given by the formula exceeds the total amount of the relevant termination award then PENP is capped at the total amount of the relevant termination award (i.e. the whole termination award will be subject to tax and NI).
You can find HMRC’s worked example here: https://www.gov.uk/hmrc-internal-manuals/employment-income-manual/eim14000
For employers, the issue is that often, the correct label is not applied to the various elements that make up a settlement sum. When an employment is terminated, an employee might be entitled to different payments such as unpaid salary, statutory redundancy pay, damages, payment in lieu of notice, payment for a restrictive covenant, compensation for loss of office etc. An employer might decide to use a settlement agreement to protect themselves from a future claim from the employee. It is important to remember that a settlement agreement is simply a legal agreement between the parties that the employee will not seek to challenge the termination in the courts; it has nothing to do with the tax calculations required with regards to the settlement sum agreed by the parties. Whether payments agreed under a settlement agreement are taxable or not is a matter of tax law. Therefore, failure to label the various elements that make up a settlement sum properly can lead to an unpleasant surprise for the employee who might be expecting a tax-free payment of the entire sum.
Another question that we asked respondents in our survey was if they would expect an outsourced payroll provider to make them aware of how to structure a relevant termination award in line with the new legislation. 76% said yes, they would. Over the last few months, we have had a number of cases where a client was not aware of the change to the taxation of termination payments and upon notifying us of a termination situation, we were able to advise them accordingly and help them avoid a potentially costly mistake.