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Changes to Taxation of Settlement Payments

The government has published draft legislation which will make changes to how settlement payments are taxed. These changes are not intended to come into force until April 2018 and will have an effect on what parties may be willing to offer or accept when entering into a settlement agreement.

At present, non-contractual payments received by way of compensation for loss of employment are subject to income tax, although the first £30,000 of such payments is tax free. There are some complications in the rules, such as exceptions for certain types of payment, and a distinction regarding payments which amount to earnings rather than compensation for termination of employment. The changes to be introduced are intended to simplify the taxation of settlement payments.

The three key changes are as follows:

  • All payments in lieu of notice (PILONs) will be taxable, even if they are not contractual.
  • Employer national insurance contributions (NICs) will be payable on settlement sums over £30,000.
  • Clarifying that injury to feelings payments in relation to termination of employment will be subject to tax.

PILONs

A PILON is generally made where it is intended for the employee to leave with immediate effect rather than working their notice. Generally, an employer is only entitled to make a PILON if there is a specific clause in the employee’s contract which allows this. In this situation, the PILON will be subject to tax and national insurance contributions as the employer is simply exercising a right to make a contractual payment.

Where there is no such clause, the PILON is a non-contractual payment which is generally taken to represent damages for the amount the employee should have received if given proper notice. Such a payment could be paid tax free, so long as it did not exceed the £30,000 exemption threshold.

The proposed change will mean that a PILON will always be subject to tax whether, there is a relevant clause in the employee’s contract or not. The rationale is to remove what is seen by some as unnecessary complexity and giving preferential treatment to those without a PILON clause. In practice, this will remove a potential advantage for employees and employers where a PILON is to be made. Under the proposed new rules, the employer will have to account to HMRC for both tax and NI where (in situations in which the employee’s contract has no PILON clause) the employee could benefit from receiving payment as gross. The loss of the obvious advantage to employees in this situation is mirrored in the fact that employers seeking to negotiate an exit package for an employee may now require to offer additional monies by way of pure compensation with a view to meeting the employee’s expectation.

This change does not remove the general distinction between other contractual payments, which would generally be taxable, and non-contractual payments, which would fall within the £30,000 exemption.

Employer NICs

As noted, settlement payments, being those which represent compensation for loss of employment, are tax free up to £30,000. Payments over £30,000 are subject to income tax, but not national insurance contributions. The new rules would mean that those payments over £30,000 would be subject to employer’s NICs as well as income tax, but would remain free of employee NICs. The reasoning behind this is that it is unfair that the employee should bear the burden of income tax but not receive NICs, and the change intends to align this.

There was some concern among respondents to the government consultation that this might increase the financial burden on employers and discourage them from making larger settlement payments, which would have an impact on employees. It was considered that, as most settlement payments are below the £30,000 threshold, this change would not have a significant effect.

Injury to Feelings

The new legislation is also intended to make clear that payments for Injury to Feelings are subject to tax. These are awards of compensation made where an employer is found liable for discriminatory treatment to which an employee has been subjected.

Generally, at present damages for “injury” will be tax free even if they exceed £30,000. It has not been clear whether Injury to Feelings awards may fall within the “injury” exception and there have been conflicting decisions on this point from employment and tax tribunals. The proposed change intends to make clear that an award for Injury to Feelings alone (as opposed to compensation for pure personal injury) does not fall within this exception, and therefore such awards will be taxable, subject to the usual £30,000 threshold.

This change will simplify the tax treatment of such payments, but the matter is still far from straightforward. While ‘injury’ in terms of the exemption will not include Injury to Feelings, it does include personal injury, including psychiatric injury which is often a consequence of discriminatory acts. Therefore, where a payment of damages is being made for psychiatric injury, it would be prudent to seek advice and ensure that a tax indemnity is included in the settlement agreement.

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