Termination payments: Get the details right, part 2
In the final part of this two-part series, Sarah Bradford explains how to calculate what is taxable as earnings and what, if any, is taxable as a termination payment within the specific termination payment rules (ITEPA 2003, Pt6, Ch3).
The calculations can be complex and the terminology is certainly confusing.
As discussed in part one of this series, the relevant termination award is taxed as earnings up to the level of the post-employment notice pay (PENP). The relevant termination award is simply the termination award (the payments made on the termination of the employment excluding normal payments, like wages and salary) less statutory redundancy pay or the equivalent paid under a contractual scheme.
Where the relevant termination award exceeds the PENP, the excess, plus any statutory redundancy pay or the equivalent paid under a contractual redundancy pay scheme, is taxed in accordance with termination payment rules, the first £30,000 of which is tax-free. The excess is taxable and liable to Class 1A NIC (paid only by employers).
Calculating the PENP
The PENP is found by looking at the employee’s ‘basic pay’ in the last pay period before the employee was given notice (or, if the employment was terminated without notice, the last day of the employment), and finding the pro-rata equivalent for the notice period. Payments which have already been received in connection with the employment and which have already been taxed (eg contractual payment in lieu of notice (PILON), holiday pay or a termination bonus) are excluded from PENP.
The legislation sets out a statutory formula:
((BP x D) ÷ P) – T
- BP is the employee’s basic pay in the last pay period of the employment ending before the trigger date.
- D is the number of calendar days in the post-employment notice period
- P is the number of days in the employee’s last pay period
- T is any payment or benefit received in connection with the termination of the employment which is chargeable to income tax other than under the termination payment rules.
The deduction of T reduces the amount of the post-employment notice pay by any payment in lieu of notice (PILON) that is taxed as earnings (for example, a contractual PILON). The value of T specifically excludes holiday pay and termination bonuses.
If the amount given by applying the above formula is negative, the amount of the PENP is taken to be nil.
If the amount given by the formula is more than the amount of the relevant termination awards, the PENP is capped at the amount of the relevant termination award.
Basic pay is the total employment income that the employee receives (or has the right to receive even if they give that right up) in their last pay period before the ‘trigger date’. However, it excludes:
- overtime, bonuses, commission, gratuities or allowances;
- amounts received in connection with the termination of the employment;
- taxable benefits taxed under the benefit in kind rules;
- other items treated as earnings such as sickness and disability payments, payments on account of tax where deduction is not possible, payments on account of a director’s tax, payments for restrictive undertakings, shares of employee shareholders treated as earnings and sporting testimonial payments in excess of £100,000; and
- employment-related securities taxable as earnings or as specific employment income.
Employee’s last pay period
In the formula for calculating the PENP, P is the number of calendar days in the employee’s last pay period ending before the trigger date. A pay period is the period that the payment represents.
Sam is paid on 15 October 2020 and the payment that he receives on that date presents the period from 1 October 2020 to 31 October 2020. Sam’s pay period is 1 October 2020 to 31 October 2020 not 16 September 2020 to 15 October 2020.
A simplified calculation using months rather than days can be used where the last pay period is a month, the minimum notice period specified in the contract is expressed in whole months, and the post-employment notice period (D in the formula) is either equal to the minimum notice period or expressed as a number of whole months. In this case, P is taken to be 1 and D is expressed in months rather than in days.
What is the trigger date?
The trigger date depends on whether notice is given or whether the employment is terminated without notice.
Where notice is given, the trigger date is the day on which notice is given. If the employment is terminated without notice, the trigger date is the last day of the employment.
Post-employment notice period
The post-employment notice period is the period beginning with the last day of the employment and ending with the earliest lawful termination date.
The ‘earliest lawful termination date’ is the last day of the period which is equal in length to the minimum notice period and ends with the trigger date.
The minimum notice that the employer must give in order to terminate the contract is determined by law and by the employment contract.
Payments taxable as earnings are included in gross pay for both PAYE and NIC. However, where a payment is taxed under the termination rules, it is only taxable, to the extent that it exceeds £30,000. There is no class 1 NIC on termination payments; instead, class 1A contributions are payable to the extent that the payment exceeds £30,000. The class 1A NI is reported to HMRC under RTI with payments for the period and paid over to HMRC, together with payments of PAYE and Class 1 NIC.
Where payments are made after the form P45 has been issued, the 0T code should be used.
Tip: Check your payroll software for the precise process that should be followed.
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Sarah Bradford BA (Hons) FCA CTA (Fellow) is the director of Writetax Ltd (www.writetax.co.uk) and its sister company, Writetax Consultancy Services Ltd. She writes widely on tax and National Insurance contributions and is the author of National Insurance Contributions 2020/21 published by...