A Simple(ish) Explanation
What can we say about the new rules surrounding taxation of termination payments? An accountant recently confessed to us that he was finding the whole area of post-employment notice pay under the new rules particularly difficult to understand. So, if the tax professionals are struggling, what chance do the rest of us have?
The new laws are far from straightforward and if you are struggling to understand them, you are not alone. But, like it or not, taxation of Post-Employment Notice Pay (or ‘PENP’) is here, and is not going away. In an attempt to help us all begin to fathom what it is all about, we set out some FAQ’s below.
So when do I need to think about PENP?
You will need to calculate the PENP, and tax it if appropriate, whenever a departing employee does not work some, or all, of his/her notice and receives a compensation payment on termination. It will also apply where an employee has given notice (whether or not they have worked that notice) and the notice period which, under the contract or statute, the employer would have been obliged to give, is greater than the notice the employee has given.
So what is PENP?
Under the old rules, in broad terms, tax was only payable on pay in lieu of notice payments where there was a contractual pay in lieu of notice (“PILON”) clause in the contract, or the employer had an established practice of paying in lieu of notice (“auto-PILON”). This meant some sums which would otherwise have constituted notice paid in lieu, could be made tax free (subject always to the £30,000 overall limit). PENP has been introduced in an attempt to make sure that all payments which equate to payment in lieu of notice are taxable as earnings, even where there is no PILON clause in the contract.
Somewhat ironically, the intention was to make the position clearer, as the issue of “auto-PILONs” had made the area complex and led to uncertainty around when tax would be payable, and in some cases challenges to Settlement Agreement arrangements by HMRC. In theory, then, whether or not there is a PILON clause in the contract should now be irrelevant, but whether this has been achieved remains to be seen.
So how do we calculate the PENP?
You might think that calculating PENP should be the same as calculating PILON. But no. That would be too easy! To calculate PENP you need to apply a statutory formula, which in some cases will result in a different ‘notice’ payment than was actually due under the contract. Whilst you don’t need to change the amount that you pay the employee, this difference will impact on the amount of tax deemed to be payable. Applying this formula can be fairly simple, or more complex, depending on the circumstances.
The statutory formula for PENP is:
(monthly basic pay x unworked notice period)
÷ length of the pay period immediately prior to notice being given*
Once you have done this calculation, you can then deduct the value of any contractual termination payment due to be made to the employee, such as a payment in lieu of notice taxed under the contract. Nb. This does not include holiday or termination bonuses.
What this means in practice is that, if you have already decided to tax the PILON payment and the PILON value is the same or more than the PENP, you will not need to do anything else (except state in any settlement agreement that that is the case). If it is less, or if you had planned to pay it free of tax, then you will have to look to tax the difference from any tax-free compensation payment being made.
*To work out the length of the pay period, you will look at the pay period immediately before notice was given. Therefore, if notice is given in June, you would look at the length of the May pay period (assuming the employee is monthly paid). This could then be expressed in days or months, depending on how you are working out the rest of the calculation.
What is basic pay? Is it the same as you would use to calculate a PILON payment?
Of course not! Basic pay for PENP purposes will be the employee’s base salary, not including any allowances, bonus, commission, benefits in kind or gratuities (most of which are often included in PILON payments). The meaning of “allowances” is not clear, but it is generally thought that if an allowance is paid automatically as part of regular monthly pay (such as a car allowance which is not genuinely a replacement for a car), it will still fall within basic pay. The big difference, however, is that you must include the value of any salary sacrifice schemes, such as childcare vouchers and employee pension payments, something which, traditionally, is not included in PILON payments. This means that if the amount of any salary sacrifice is significant, the PENP may work out at more than the PILON amount, meaning part of the compensation payment will be taxable.
So if the PENP is more than the PILON, what happens then?
The next step is to look at what other payments are being made to the employee, and their tax treatment. Ultimately, if there is any payment being made tax free, then the difference between the PENP and the PILON will need to be taxed, even where the tax free payment would otherwise be a legitimate tax free payment. However, you do not have to tax any statutory redundancy payments and these can still be paid tax-free even where there is a PENP liability.
Does this apply retrospectively?
No. PENP only applies to payments made on or after 6 April 2018 where termination of employment also occurred on or after 6 April 2018.
Is there anything else I should be thinking about?
Just a few further points to remember:
- You will need to apply PENP even in gross misconduct situations;
- You will always be looking at the employer’s notice period – meaning that if an employee gives notice, but the notice period due from the employer is longer than that notice, it is likely that there will be a PENP liability;
- Some commentators have suggested that PENP will not bite where pay in lieu of notice has been paid under a PILON clause in the contract and so will only bite in situations where there is no contractual PILON. However, this is far from certain, and it would be a much safer approach to apply it in all cases; and
- These are still early days and there is much uncertainty and lack of clarity around the new rules. Hopefully we will get clear guidance soon, which may alter some of the advice above.
My head hurts! Please can I have some example calculations to help make sense of this all?
Example 1 (the easy one):
If contractual notice period is expressed whole months AND final pay period pre-notice is one month AND no notice has been worked, the calculation is:
((BP x D) – T
BP (basic pay, including salary sacrifice) = £3000 p/m
D (unworked notice period) = one month
T (contractual payments made other than holiday or termination payments, including contractual pay in lieu of notice) = £0
PENP = 3000 x 1 = £3,000
This amount will need to be taxed from any compensation payment made.
Where some notice has been worked
((BP x D) ÷ P) – T
BP =£3,000 per calendar month (incl. any salary sacrifice)
Notice period is 3 months (92 days) and the period of notice worked is 17 days
D (unworked notice period) = 92 – 17 = 75 days
P (pay period) = one month – notice is given in June so look at May = 31 days
T (contractual payments including PILON = £0
((3000 X 75) ÷ 31) – 0 = £7,258.06
PENP = £7,258.06
This amount must be taxed from any compensation payment
Where paid monthly, but notice period expressed in weeks AND a PILON has been paid on a taxable basis.
((BPxD) ÷ P) – T
BP = £10,000 p/m (including £1,000 salary sacrifice)
Period of notice worked = 0
D (unworked notice) = 12 weeks (84 days – NB this amount will vary depending on which month notice is given and the length of the following months)
P (pay period) = one month (30 days) (notice served in July so pay period is June)
T (PILON paid) = £24,923.10 ((9000 x12) ÷ 52)
(10,000×84) ÷ 30 = £28,000
£25,200 – 24,923.10 (PILON) = £3,076.90
PENP = £3,076.90 – must be taxed from any compensation payment