New tax rules are due to come into force on Friday 6 April 2018 requiring income tax and national insurance contributions (NICs) to be paid on all payments in lieu of notice (PILONs) on termination of employment.

Presently the first £30,000 of any PILON can be paid tax-free on termination provided there is no express contractual right to make such a payment within the employment contract and (in the absence of an express contractual right) the employer has not created an implied right by adopting a consistent practice of making PILON payments to departing employees. This allows the payment to be treated as damages for breach of contract.

This practice is commonly followed by employers seeking to take advantage of the freedom to pay an employee their notice pay gross on the termination of their employment. In addition to this an employer can also elect to simply breach the contract and make a payment which genuinely reflects factors such as mitigation albeit without the same security of knowing that it won’t be subject to income tax and NICs.

The new changes will require all PILONs to be taxed as earnings, whether they are contractual or not. This will mean that employers will no longer be able to avoid paying tax by classifying PILONs as damages for breach of contract/compensation. The new rules will require employers to calculate an employee's "post-employment notice pay" (PENP) ie the amount of basic pay the employee will not receive because their employment was terminated without full notice being provided. This PENP is taxable and subject to income tax and NICs even if described as compensation. The balance of any termination payment in excess of the PENP will then still be tax free up to £30,000.

HMRC guidance confirms that the new rules will apply to all payments made after 5 April 2018 provided that the termination payment is made after 5 April 2018 and the employee’s employment terminated after 5 April 2018. The new rules will not apply if the employment terminates before 6 April 2018, even if payment is made on or after 6 April 2018.

The new rules are likely to increase the costs of settling termination claims for employers as there will be no scope to effectively pay what would have been the income tax and NICs on notice pay to a departing employee. They will now be required to account to HMRC for the income tax and NICs given that otherwise they will be liable to HMRC for substantial penalties and interest. This in turn will increase the what employers will probably pay in compensation to the employee.