Settlement agreements currently allow employers to end the employment relationship by mutual agreement with payment of an agreed lump sum and possibly other benefits.
For years employers have been offering ‘compensation’ for not giving notice and as compensation, this amount would be tax free.
However, the government has reviewed this and changes coming into force from 6 April 2018 mean all termination payments will attract tax and National Insurance contributions.
In simple terms, from 6 April, all settlement agreements need to clearly set out how the amounts have been determined and this will in turn, determine the tax treatment of those payments.
Payment in lieu of notice and notice pay generally must be subject to usual deductions.
To fix the matter, HMRC now has Post Termination Notice Pay, which is determined by the following (slightly complex) calculation.
BP = basic pay in the last pay period to end before the termination date
D = the length of notice period
P = number of days in last pay period
T= the amount of any payment or benefit received in connection with the termination which:
• is not already subject to tax under another section of legislation,
• is not paid in respect of holiday pay,
• is not a bonus payable for termination of employment.
In short, employers will be required to tax as earnings the part of a termination payment that is equivalent to the earnings the individual would have received had their notice period been worked in full.