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Ask Auntie - What are the new tax rules for salary sacrifice and termination payments?
I have a couple of tax-related questions. We offer salary sacrifice scheme for employees so that they can increase pension contributions, take more holiday and access certain flexible benefits. I’ve been told we will need to change this soon. Also, we are planning to offer some employees settlement agreements and I seem to remember reading that we need to start taxing termination payments differently. Is this all correct?
Ta - x
The last year has seen a raft of proposed changes in the area of employment tax, some of which supposedly simplify matters (though in the main they seldom do), and some of which are aimed at curbing what HMRC see as arrangements motivated by tax or NIC avoidance.
There has been much confusion as a result of continuous amendments at consultation and draft legislation stages, the removal of certain provisions from the recent Finance Bill to allow early passage of the Bill into law before Parliament was dissolved in advance of the General Election, and the loss of the Conservative majority following that election. This against a background of increasing uncertainty from both an employment law and tax perspective in relation to employment status, in particular with regard to the “gig” economy, culminating in a number of high profile cases and governmental reviews, and the effective changes to the IR 35 rules albeit limited (for now) to the public sector.
Two areas where there does appear to be some clarification and certainty as to the direction of travel are salary sacrifice and termination payments, although in the latter case the legislation has yet to be introduced. We briefly look at the changes in these areas, and the opportunities going forward, below.
It is fair to say that HMRC have been unhappy for a while now with salary sacrifice arrangements, whereby an employee gives up part of his/her entitlement to salary or bonus (which is subject to income tax/NICs) in exchange for new or enhanced non-cash benefits which benefit from a full or partial exemption from tax or NICs (or both). Although there are a number of non-tax reasons for implementing such arrangements, one of the principal drivers has been the tax, and in particular, NIC savings, and they were clearly starting to cost the Government too much money.
Salary sacrifice arrangements attracting beneficial tax/NIC treatment will still be possible, but over a much more restrictive list of benefits, being:
- employer contributions to registered pension schemes and pension advice
- employer supported childcare arrangements
- cycle to work schemes
- ultra-low emission cars
It should also continue to be possible to make a salary sacrifice in return for intangible benefits – such as extra annual leave – but this has still to be fully confirmed by HMRC.
Care will need to be taken going forward not to accidentally fall foul of the new rules, which apply to “optional remuneration arrangements”. This term is defined very widely and can cover any arrangement where an employee (or future employee) either (i) gives up a right (or future right) to receive an amount of earnings in return for the benefit, or (ii) opts for the benefit instead of a cash allowance. If so, then the employee will be subject to income tax on the higher of the salary (or cash allowance) sacrificed and the cash value of the benefit (determined under the existing benefit rules but with certain modifications). The employer will also be liable to pay Class 1A NICs.
Whilst the new rules came into force on 6 April 2017, existing schemes will still be effective until 6 April 2018 (or 6 April 2021 for cars, accommodation and school fees). But care will need to be taken if you are making any amendments to existing schemes to ensure that this does not prejudice the position.
Following a lengthy consultation process, where extensive amendments were proposed to the tax treatment of termination payments and almost universally criticised as being far too onerous and complicated, more restricted changes will (probably) apply as from 6 April 2018. The legislation was dropped from this year’s Finance Act, but in all probability will be re-introduced early in the next Parliament (regardless of the make-up of the government).
The main points to note are as follows:
- the £30,000 tax free threshold will be maintained, but the Treasury will have the power to vary this by regulation (it remains to be seen whether this would be up or down!)
- Class 1A NICs (employer only) will be payable on all termination payments above the £30,000 threshold
- all PILONs (whether contractual or not) will be treated as general earnings (and liable to income tax and class 1 NICs) – see further below
- payments for injury to feelings, say as a result of discrimination arising in connection with the termination, will fall outside the disability exemption (unless they amount to a psychiatric injury or other recognised medical condition)
- the foreign service exemption will be abolished
Particular care will need to be taken under the new rules to ensure that any amount of a termination payment which equates to what the employee would have received by way of notice pay had they worked their contractual notice period (their “post-employment notice pay”) is subject to PAYE tax and class 1 NICs in the normal way. This is regardless of how the amount is paid and what it is stated to relate to as a contractual matter. Only those amounts which exceed the “post-employment notice pay” will continue to be taxed as a termination payment. So it will no longer be possible to argue that an employment contract (which does not include a contractual PILON) has been terminated in breach of the notice period and make a damages payment which falls within the £30,000 exemption.
Take employee A who is paid £7,000 monthly and has a 3 month notice period but no contractual PILON. A’s employment is terminated without notice and A receives a termination payment of £35,000. Previously the full £35,000 would have been treated as a termination payment, but from 6 April 2018 it will be necessary to identify the “post-employment notice pay” (£7,000 x 90/30) of £21,000 and subject that to PAYE income tax/class 1 NICs with only the remaining £14,000 taxable as a termination payment.
On a brighter note, there are still certain planning opportunities. For example, despite the changes, it may still be possible to argue that payments in respect of compensation for pre-termination discrimination (including injury to feelings) can be made tax free.
If you would like any advice or assistance in implementing salary sacrifice schemes or amending existing schemes, or structuring termination payments, please contact Emma Bailey on firstname.lastname@example.org; 0207 614 2560 or your usual contact at Fox Williams.