A number of tax changes to settlement agreements came into force from the 6th April 2018. Further changes take effect from the 6th April 2019
Tax Changes To Settlement Agreements: 6th April 2018
Prior to the 6th April 2018, where the employment contract provided for pay in lieu of notice (PILON), then the PILON was taxable in the normal way as earnings. However, where there was no provision for PILON in the contract of employment, then the PILON was not taxable, as the payment of PILON constitutes a breach of contract. Accordingly, the payment of it would equate to damages, the first £30,000.00 of which can be paid tax free pursuant to the exemption contained in sections 401 to 404A of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA).
From the 6th April 2018, however, all payments of PILON have been regarded as earnings and are taxable in the normal way, regardless of whether PILON was provided for in the employment contract. The Governments position is that this will reduce manipulation of the rules/tax avoidance, although the ultimate result of the rule change is that it will yield a higher tax take than what would have been the case had the scope for tax avoidance simply been removed, as the fact is that all PILON is now taxable.
One problem with the rule change relates to how PILON is calculated, as it can either be based solely on basic pay, or it can include bonuses, contractual benefits, etc. Accordingly, the legislation underpinning the rules changes includes a formula on how to calculate what it refers to as ‘Post Employment Notice Pay’ (PENP). That formula is now set out in section 402D ITEPA 2003, and can be found here and here.
Nevertheless, ambiguity remains in relation to some scenarios. For instance, in cases of summary unfair dismissal under which no notice payment is paid by the employer, but where notice pay is incorporated into a subsequent settlement package, no guidance has been provided by the Government. Furthermore, in cases of salary sacrifice, for example, the PENP formula calculation can sometimes produce a different total compared with what is provided for by the contract of employment.
The tax treatment has also changed in relation to injury to feelings awards, which were tax free prior to the 6th April 2018 (a position confirmed by the Court of Appeal decision in Krishna Moorthy v HMRC  EWCA Civ 847). Since the 6th April 2018, following an amendment to section 406 of the ITEPA 2003 by section 5(7) of the Finance (No 2) Act 2017), awards for injury to feelings are now only tax free where the injury relates to a psychiatric injury. Accordingly, awards for injury to feelings such as upset, where there is no psychiatric injury, are now taxable.
Tax Changes To Settlement Agreements: 6th April 2019
From the 6th April 2019, employers will now have to pay class 1A national insurance contributions on that part of the termination payment that exceeds the £30,000.00 exemption. This change was originally due to come into force from the 6th April 2018, but was put back to the 6th April 2019.