Common pitfalls employers face when calculating post-employment notice pay?

Undertaking post-employment notice pay (“PENP”) calculations when an employee leaves a business can be complex and easy to get wrong. We discuss some of the issues facing employers when carrying out these calculations.

Background

PENP is relevant to determining the correct tax treatment of termination payments. For tax purposes, a termination payment is any payment made in connection with the termination of an employee’s employment which is not otherwise subject to income tax under a separate statutory provision. Typical termination payments include: ex-gratia payments, compensation for unfair dismissal or damages for wrongful dismissal.

Termination payments can be paid tax free up to £30,000. The PENP was introduced to prevent employers from arguing that amounts effectively paid in lieu of notice were ex-gratia payments or damages for breach of contract so that such payments could be treated as termination payments and benefit from the tax free treatment up to £30,000. 

Rules governing the calculation of the PENP are complicated; but broadly it works by treating an amount equal to the PENP, being the amount the employee should have received had they worked their full notice period, but which they have not actually received, as earnings from employment (and thus subject to income tax and National Insurance contributions).

The PENP is worked out by reference to a formula set out in the legislation. The formula works by calculating the amount of pay the employee should have received during the notice period and then reducing this by any amount paid to the employee on termination of employment which is already taxable (to avoid double taxation).

If the PENP is a positive figure then this amount will be deemed to be earnings (and will be subject to Income Tax and National Insurance contributions). If the PENP figure is nil or negative then no additional tax will arise and the whole of the termination payment will be entitled to tax free treatment up to £30,000.

Statutory redundancy pay and non-statutory redundancy pay

The PENP does not affect the tax treatment of statutory redundancy payments. Statutory redundancy payments are not relevant termination awards for the purposes of the tax rules. Therefore, statutory redundancy payments will always be treated as being tax free up to £30,000 – even where there is a positive PENP.

Non-statutory redundancy payments (e.g. redundancy pay in excess of the statutory redundancy pay entitlement) are not excluded from the definition of relevant termination awards and as such these payments will only be entitled to benefit from tax-free treatment up to £30,000 to the extent there is not a positive PENP (if there is a positive PENP then the relevant amount will be taxable as earnings).

Salary sacrifice arrangements

PENP is calculated by reference to an employee’s basic pay (“BP”) ignoring any amount which the employee has given up the right to receive (i.e. if a salary sacrifice arrangement is in place this would be the pre-sacrificed amount of the employee’s salary). This could mean that the PENP exceeds the amount actually paid by an employer in lieu of notice if such amount is based on the employee’s post-sacrifice salary. In such a situation, the amount by which PENP exceeds the notice pay will need to be accounted for from any ex-gratia award resulting in part or all of that award becoming subject to tax.

This also has the effect of potentially reducing the tax benefit arising from such a salary sacrifice arrangement. For example, where salary is sacrificed in return for additional employer pension contributions, the effect of the PENP calculation is to treat the higher pension contributions as earnings and subject to income tax, even though had the employee made the pension contributions themselves, such pension contributions would not have been subject to income tax (it may also lead to a double tax charge on the employee as they will be subject to income tax on crystallisation of at least some of the benefits from the pension scheme).

Pension contributions to a registered pension scheme which are made as part of an arrangement relating to the termination of a person’s employment are not treated as termination payments for tax purposes (therefore these are never subject to the PENP). Tax efficiencies may therefore be realised by an employee directing some or all of a payment received on termination of employment to a registered pension scheme.

However, if an employee is thinking of doing this specialist advice should be taken. Tax charges may arise if an individual exceeds the annual or lifetime allowance (which are both tested against the employee’s holistic pension position) and funds directed into a pension scheme may be not be withdrawn in a tax efficient way until the employee has reached a certain age or satisfies other criteria (so these funds may be inaccessible in the medium to long term).

Payment in lieu of holiday pay

When undertaking the PENP calculation it is necessary to reduce the amount of pay the employee should have received during the notice period by an amount known as (“T”). T comprises amounts that are paid on termination but are otherwise taxable as earnings (such as contractual payments in lieu of notice). This is to ensure that the same amount is not subject to double tax. However, T does not include payments in lieu of holiday entitlement for a period before employment ends.

It is unclear whether a payment in lieu of accrued but untaken holiday entitlement should be included within the definition of BP for the purposes of working out the PENP.

Where a payment in respect of holiday entitlement has been made in the last pay period (on the basis that it would be unusual to make such a payment part way through employment) the payment could be:

  • treated as employment income and therefore included within BP. This will increase the BP figure which will in turn increase the PENP amount (with no corresponding reduction in the amount comprised in T); or
  • an amount received in connection with the termination of employment and therefore subject to tax in its own right but excluded from BP (this would essentially be a tax neutral treatment as it would have no effect on the calculation of BP). This tends to be the more popular approach.

Although it may be difficult to justify that a payment in lieu of holiday entitlement is a termination payment given that it arises in connection with rights arising under the employee’s contract of employment and it would be paid in the last pay reference period prior to termination and therefore may not be sufficiently connected with termination, equally it is arguable that such a payment would not have arisen but for the termination, and in fact, payment in lieu can only be made on termination, supporting the view that it is a termination payment.

Where an employee disputes their dismissal for gross misconduct

Where a dispute arises following an employee’s termination for gross misconduct, there will likely be a difference in position as to whether or not notice should have been given. An employer will argue that it did not need to provide notice due to the summary dismissal whereas an employee that disputes the dismissal for gross misconduct will argue that notice should have been served on the basis that they should not have been dismissed summarily.

This can present difficulties when undertaking a PENP calculation, given that a figure needs to be included representing the number of days in the unexpired notice period (“D”). HMRC has confirmed that for the purposes of the calculation where there is a dismissal for gross misconduct the figure to be entered for D is nil. However, employers should note that D will change from nil to the amount of notice the employee was entitled to as at the termination date where a settlement agreement is entered into ahead of the disciplinary process outcome being given so there is no actual finding of gross misconduct or a finding of gross misconduct is overturned e.g. following an appeal or by an employment tribunal decision.

Summary

PENP calculations are fraught with difficulties. What is clear is that careful consideration of the amounts being paid and their treatment for tax purposes is needed, and this may require legal advice and/or HMRC clearance.

Disclaimer

This information is for educational purposes only and does not constitute legal advice. It is recommended that specific professional advice is sought before acting on any of the information given. © Shoosmiths LLP 2024.

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