Handling staff exits is challenging enough without falling foul of tax rules that affect termination payments. Avoid an awkward chat with HMRC by getting a grip on how common pay arrangements interact with PENP, says John Weston, associate director in the employment tax team at BDO.
When it comes to workforce reductions, employers will often be as considerate as possible with regard to the financial implications for the employee. However, when negotiating the exit of employees who are not required to serve their full period of notice, unforeseen complications can arise.
These often result from the tricky interaction of the tax rules that govern post-employment notice pay (PENP) and arrangements entered into either during the course of the employment (i.e. salary sacrifice) or as part of the termination package itself.
Both of these kinds of arrangements are commonplace and are often made available to secure the tax and national insurance contribution (NIC) advantages of additional employer pension contributions. Unfortunately, when this happens in connection with a termination payment, an employee can find that not as much of their accompanying payment is free of tax/NIC as they expected. This can cause potential embarrassment for the employer, who, perhaps having overlooked the complications, fails to deduct sufficient PAYE/NIC and is then faced with making a disclosure to HMRC.
Know your PENP
To recap, the PENP rules were introduced in April 2008 to resolve the difficulties that previously existed around the tax profile of payments in lieu of notice (PILON), based on whether they were contractual, non-contractual or were described as anything else. The rules broadly state that if an employee does not work their full notice period (be that statutory or contractual), they should have PAYE/NIC deducted from so much of their termination payment as equates to their entitlement to be paid for that period.
While the rationale for the rules is easy to understand, the difficulties arise from how PENP is defined and calculated. This can in turn lead to an unexpected amount of the termination payment being treated as taxable earnings subject to PAYE/NIC, rather than potentially eligible for the £30,000 exemption.
Basic reference
Firstly, PENP is calculated by reference to what is termed basic pay before any salary is sacrificed – rather than what an employee may have been receiving after it.
Therefore should an employer be making and taxing a PILON based only on the employee’s pay entitlement net of any salary sacrificed, this will be less than the value of the PENP. That, in turn means that if there is any remaining part of the termination payment (ignoring statutory redundancy pay) which hasn’t been subject to PAYE/NIC, because it is thought to benefit from the £30,000 exemption, this will become taxable up to the value of the difference between the PENP and the PILON which has been calculated by reference to net pay.
Secondly, when it comes to negotiating the termination payment itself, it can be tempting for an employee to think that if the PILON (contractual or otherwise), is going to be subject to PAYE/NIC in full, that they might achieve a more tax-efficient termination package than the one on offer by giving up some or all of this in favour of pension contributions.
Unfortunately, this is not how the PENP rules work. Even though no PILON payment is actually made, an amount equal to what would otherwise have been paid needs to be subjected to PAYE/NIC. In practice, that means that an amount, which could be potentially significant, and would otherwise be matched against the £30,000 exemption, will be subject to PAYE/NIC after all.
Access denied
Even if you consider the important timing and documentation factors of a salary sacrifice arrangement, the PENP rules can still prevent you from achieving the intended tax and NIC savings.
I’ve focused on how salary sacrifice arrangements can impact termination payments, but there are a host of other complications which can make the £30,000 exemption much less accessible than employees and employers might expect.
We have identified up to 63 different data points that may need to be considered for each termination tax calculation. Of course, problems discovered only after the employee has left and that relationship has ended can, understandably, be difficult to put right and HMRC will inevitably approach the employer in the first instance to remedy any identified shortfall in PAYE/NIC.
Therefore, wherever circumstances allow, prudent employers should aim to model the PAYE/NIC profile of a termination payment in conjunction with their professional adviser well in advance so that costs of termination arrangements are kept under control.
