Business owners who employ members of staff must occasionally make the difficult decision to terminate an employee's contract.

Termination payments can be complex, as the package usually comprises several different elements which may be treated differently for tax and national insurance purposes.

In a bid to simplify matters, the way in which termination payments are taxed changed when the new financial year began on 6 April 2018.

The rules introduced a new approach and reclassified some payments that previously benefitted from the £30,000 exemption as earnings.

The £30,000 exemption remains in place, but its scope is more limited.

The new rules remove some ambiguity surrounding payments in lieu of notice, which are usually taxed as earnings, regardless of a contractual entitlement or customary expectation to the payment.

New rules, new approach

Under the new rules, payments made on the termination of an employment may be taxed either as earnings or as a termination payment benefitting from the £30,000 threshold. However, there is a new approach to determining which side of the fence the payment falls.

The approach is to look at the earnings an employee would've received during their notice period and compare it to the payments made on termination (adjusting for certain exempt items).

The termination payment is taxed as earnings up to the level of the earnings the employee would've received had they remained employed, with any excess taxed as a termination payment benefitting from the £30,000 threshold.

The process

The first stage is to identify the amount of the termination award which doesn't benefit from the threshold and is taxed as earnings.

A termination award comprises payments or other benefits received directly, indirectly or in consequence of the termination of employment.

Having identified the termination award, the next step is to identify the relevant termination award.

This is the termination award excluding redundancy payments or an approved contractual payment, which is no more than the amount that would've been due had a redundancy payment been made.

The new rules introduce the concept of post-employment notice pay, which is the benchmark by which termination awards are judged to see what side of the fence they fall.

The relevant termination award is then compared to the post-employment notice pay to determine how much of it is taxed as earnings and if any of it benefits from the £30,000 exemption.

New tax treatment rules

The new rules compare the termination payment made to your employee with what they would've received had they remained in the job.

The following rules apply to determine the amount taxed as earnings, and if any of that benefits from the £30,000 exemption.

Rule 1

If the post-employment notice pay in respect of the termination is greater than or equal to the total amount of the relevant termination awards in respect of the termination, all the relevant termination awards are taxed as general earnings and do not benefit from the £30,000 exemption.

Rule 2

If the post-employment notice pay in respect of the termination is less than the total amount of the relevant termination awards in respect of the termination, but is not nil, the part equal to the post-employment notice pay is taxed as general earnings.

Planning ahead

Under the new rules, the higher the post-employment notice pay, the more of the termination award is taxed as earnings.

The post-employment pay can be affected by overtime or bonuses if they are paid in the last pay period. Planning ahead can prevent distortions to the post-employment notice pay.

Looking further ahead, a new class 1A (employer-only) national insurance charge is due to be introduced from 6 April 2019. This will apply to termination awards taxed as termination payments if they exceed the £30,000 threshold.

We can advise on termination payments.

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