Simplifying the tax and NIC treatment of termination payments

Budget 2016 announced changes to the taxation of termination payments, following a consultation launched in summer 2015. The government noted that “certain forms of termination payments are exempt from employee and employer national insurance contributions (NICs) and the first £30,000 is income tax free”.

It added: “The rules are complex and the exemptions incentivise employers to manipulate the rules, structuring arrangements to include payments that are ordinarily taxable such as notice and bonuses to minimise the tax and NICs due.” From April 2018, the government would “tighten the scope of the exemption to prevent manipulation and align the rules so employer NICs are due on those payments above £30,000 that are already subject to income tax”.

The government said it would “continue to support those individuals who lose their job”. The first £30,000 would remain exempt from income tax and the full payment would be outside the scope of employee NICs.

A note of the outcome of this consultation was posted on 10 August, and a second consultation inviting comments by 5 October includes draft income tax legislation for Finance Bill 2017. Draft NICs legislation is expected in autumn 2016.

In summary:

  • All payments in lieu of notice will be subject to tax and NICs: “Any payment that covers part of the existing contractual entitlement, including the notice period even if the employee does not work it, will be taxed and subject to class 1 NICs as earnings. Anything that is non-contractual will be the termination payment which will be taxed and subject to employer NICs on any amount that exceeds the £30,000 threshold.”
  • Payments above £30,000 will be subject to employer (but not employee) NICs as well as income tax.
  • Foreign service relief will be removed: “Today there is a global workforce and this exceptional treatment is no longer justifiable.”
  • The exemption for injury will not apply in cases of injured feelings, because of “the divergence of judicial decisions” on this issue: “In order for the exemption to apply (from April 2018) there must be an injury or disability of a physical or psychological nature that is sufficient to cause the employee to be unable to perform his or her job properly.”
  • The £30,000 income tax exemption will be retained, and employees will continue to benefit from an unlimited employee NICs exemption, in order to “to minimise the impact on individuals”.

Why does this have to be so complicated? Mainly because income tax and NICs have their own primary and secondary legislation.

The income tax charge on employment income is made under Income Tax (Earnings and Pensions) Act 2003, which defines for this purpose “employment income”, “general earnings” and “specific employment income”. There are special rules for payments and benefits on termination of employment.

Liability to class 1 NICs, however, arises under Social Security Contributions and Benefits Act 1992 when earnings are paid to or for the benefit of an employed earner. “Earnings” and “earner” are defined in that Act.

The Office of Tax Simplification (OTS) is examining options for “closer alignment” (not a complete merger) of income tax and NICs. The OTS reported in March that its small business review had:

  • found that differences in the rules and procedures between the income tax and NICs systems were “the second highest source of complexity for small businesses”, and
  • identified that maintaining two separate systems led to a number of anomalies, “helping to distort business behaviour”.