Settlement Agreements: April 2018 Tax Reforms

Settlement Agreements

From 6 April 2018, the Government is introducing tax reforms which may impact the way that your business taxes payments in lieu of notice. Previously, an employment contract which did not contain a payment in lieu of notice (‘PILON’) clause, gave the employer the option to pay the employee their notice pay tax-free, up to £30,000.   

From 6 April, this changes, and payments made in relation to notice periods which are not worked will need to be taxed and subjected to employer and employee National Insurance Contributions. This will be the case irrespective of whether or not there is a PILON clause in the employment contract.  

When entering into a settlement agreement, if the parties have not dealt with, and taxed, the salary due in relation to an employee's notice entitlement separately, a "post-employment notice pay" tax liability could be charged on the termination payment.  

The employer would receive a tax demand for this amount, and there could be penalties, interests and costs charged. Whilst settlement agreements usually contain tax indemnities from employees, enforcing an indemnity is unlikely to be straightforward. 

Calculating Post Employment Notice Pay 

The new statutory rules require employers to split a termination payment between amounts treated as taxable earnings, and amounts benefiting from the £30,000 exemption.  

Practically this means that, when making a termination payment which includes notice pay under a settlement agreement, employers will have to carry out a specific statutory calculation to determine how much of the payment is “post employment notice pay”.  Once established, this sum must then be set out in the settlement agreement and taxed appropriately.  The remainder of any termination payment can still be paid tax free, up to £30,000.  

For the purposes of this calculation, the post employment notice period is often going to broadly align with the unworked notice period.  Under statute, the period is equal to the minimum notice an employer must give by contract or law to terminate employment.  This period commences on the last day of employment and ends on the earliest lawful termination date.   

The statutory calculations are relatively straightforward for those paid on a monthly basis, with notice periods expressed in months. However, the calculations are more complicated for those who are not paid on a monthly basis or whose notice periods are not expressed in months. This means additional care will need to be taken to ensure the right amount is taxed.    

Comment 

In summary then:

  • there are no longer any tax advantages to achieve by having no PILON clause in a contract of employment. It would be worthwhile considering whether to amend your employment contracts to include PILON clauses. We would recommend such PILON clauses are limited to payments of basic salary only, and that sums can be paid in instalments.
  • if you do not have PILON clauses in your contracts, you may wish to review the length of your notice periods to ensure that notice periods are not excessively long (resulting in more of the payment being taxable under the new rules). You should also review whether notice periods should be expressed in months rather than weeks. This would simplify the calculation of the taxable notice pay under the new rules.
  • the changes to tax rules will push up average settlement costs for some employers, and you should consider other tax efficiency options when negotiating settlement agreements, for example, making payments into the employee’s pension. In some circumstances, you may be able to agree that a dismissal was for ‘gross misconduct’ and therefore without notice. This potentially removes the requirement to tax notice pay under the new rules (although note that this is a grey area under the legislation).
  • you should consider whether changes need to be made to your template settlement agreements, to refer to the post employment notice period. We can provide you with draft wording, if you require.