Termination payments

12 April 2018

This article was featured in the May 2018 issue of the magazine.

John Harling, principal employment taxes consultant for PSTAX, explains what is changing

Changes to the rules regarding the treatment of termination payments for income tax and National Insurance contributions (NICs) purposes are being introduced. 



From 6 April 2018, all payments in lieu of notice (PILONs) – whether contractual or non-contractual – will be fully subject to a charge to tax and class 1 NICs. This rule change is intended to end the confusion regarding the treatment of PILONs that existed prior to 6 April which many have found difficult to interpret. 

Under the rules that applied to 5 April 2018, if a PILON was paid in termination or redundancy situations and arose from a contractual provision then it should have been subject to tax/NICs in full. ‘Contractual’ includes not only the terms of the contract of employment itself, but also other written provisions associated with employment, e.g. standard terms and conditions, staff handbook and the employer’s redundancy policy. 

Therefore, if there was a stated provision that the employer would or could pay a PILON – and that right was exercised – then the payment was subject to a tax/NICs charge on the ground that it arose from the contract of employment.

Where a contract of employment was silent on PILONs and the employer terminated the contract without requiring the employee to work their notice period, then any PILON should have been free of tax (within the overall £30,000 threshold) and NICs. However, this was complicated by the fact that HM Revenue & Customs (HMRC) has long-held the view that non-contractual PILONs that are made ‘customarily’ or ‘automatically’ on termination are subject to tax/NICs in full. 

Understanding what constitutes customarily or automatically has been the cause of much uncertainty and confusion for many years, and we do not intend to revisit those arguments here. The rule changes are intended to remove that uncertainty and treat all PILONs in the same way however they arise.


...does not explicitly state that non-statutory redundancy pay may be excluded, so we await HMRC confirmation... 


How the new rules work

The changes from 6 April 2018 introduce the concept of ‘post-employment notice pay’ (PENP), which represents the amount of basic pay the employee will not receive because their employment was terminated without full, or proper, notice being given. 

PENP is calculated by applying the prescribed formula (see box) to the total amount of the payment, or benefits paid in connection with the termination of an employment. This element of the payment should be subject to tax and NICs – both primary (employee) and secondary (employer) – in full. 

After undertaking this calculation any remaining balance of the termination payment, or benefit, which is not a PENP may be included within the overall £30,000 exemption for tax purposes and is free from NICs.

Note that there must be a relevant termination award for these rules to apply. Therefore, if the employee receives nothing, e.g. because they mutually agree to terminate their contract and leave immediately without any pay-off, there is no notional calculation required and no tax liability to consider.

HMRC’s advice in its recent Employer Bulletin (https://bit.ly/2FZsC6k) and Agent Update (https://bit.ly/2GxX5wI) states that statutory redundancy pay is not part of the PENP calculation and can continue to be paid free of both tax (within the overall £30,000 tax exemption) and NICs. It does not explicitly state that non-statutory redundancy pay may be excluded, so we await HMRC confirmation on this point.

HMRC has advised that detailed guidance on how and to what payments the PENP formula will be applied will be published in its Employment Income Manual in due course. However, at the time of writing this article, this guidance still has not been published.


The formula 

(BP × D ÷ P)  - T


BP = the employee’s basic pay for the last pay period (week or month) before the date on which notice is given. For the purposes of the calculation, basic pay excludes overtime, bonuses, commissions, allowances, and benefits in kind

D = the number of days in the PENP (the period from the last day of employment to the date when the notice period would have expired if given in full)

P = the number of days in the last pay period, and

T = are amounts paid on termination (other than holiday pay and termination bonuses) that are already taxable as earnings (e.g. a contractual PILON).



Alex has a monthly basic salary of £4,000, a three-month notice period and no PILON clause in the contract of employment (or elsewhere). 

The employer decides to dismiss Alex without notice and the parties agree on a termination payment of £24,000, which is the equivalent of six months’ salary. 

Note that though the termination payment may not specifically refer to a PILON, it would still be regarded as a ‘relevant termination award’ and the PENP calculation rules applied. 

The settlement does not include any redundancy pay element, whether statutory or otherwise. 

Alex’s PENP is £12,000 (i.e. one month’s pay of £4,000 × three months’ notice ÷ one month pay period). 

For the purposes of this calculation we have used whole months with one month incorporating thirty days, but please note that the actual number of days must be used for the calculation. This amount will be treated as earnings (and thus fully subject to tax/NICs). 

The remaining £12,000 remains eligible for exemption within section 401 of the Income Tax (Earnings & Pensions) Act 2003 and may be paid free of tax/NICs. 

As there is no contractual PILON in this case there is no reduction required using ‘T’ in the formula.


...great care should be exercised, and advice taken where appropriate...


£30,000 threshold alignment

For many years the rules regarding termination payments have seen a mismatch between the tax and NICs treatment in respect of the £30,000 tax threshold that can apply to certain termination awards. A payment that is genuinely compensatory in nature paid on termination does not currently attract any NICs charge even if it exceeds £30,000, whereas it will be subject to a tax charge if it exceeds that threshold. Though the new PILON rules will mean that certain payments will be brought into charge, the principle remains that the £30,000 threshold, for now, applies only for tax purposes.

An important change will occur next year which will mean that, alongside income tax, employer NICs will be chargeable on any termination payments made in excess of the £30,000 exemption after 6 April 2019. This change was initially intended to come into effect from 6 April 2018 but has been postponed. The additional charge will be a class 1A rather than a class 1 liability. Termination payments that qualify for exemption under section 401 will remain exempt from class 1 NICs. 

The rules regarding the tax/NICs treatment of terminations payments are complex and great care should be exercised, and advice taken where appropriate, to ensure that they are correctly applied.