Tax treatment of notice pay

One of the most frequent questions we are asked by employers is how to deal with an employee’s notice pay entitlement.

It is easy when an employee works their notice, the notice pay is dealt with in the usual way as their other wages or salary and will be subject to the usual deductions for Tax and National Insurance Contributions.

But what about an employee who is not required to work their notice and instead will receive pay in lieu of notice?

It has long been the case that where there is a contractual right enabling an employer to make a payment in lieu of notice, such a payment will be subject to deductions for both tax and National Insurance.

If no such clause exists then it was permissible to make the payment without deductions.

However changes will be introduced by HMRC with effect from 6 April 2018.

With effect from this date all payments in lieu of notice applicable to the termination date of an employee’s employment on or after 6 April 2018, must be treated as earnings and will be subject to deductions for both Tax and Class 1 NICs.

In addition, all other termination payments in excess of £30,000.00 will be subject to Employer Class 1A NICs.

The deductions apply to an employee’s basic pay.

Basic pay is defined as employment income not taking into account payments such as overtime, bonuses, commission and benefits in kind.

It is important to note that any pay in lieu of notice will be subject to deductions for Tax and National Insurance even if they are stated to be included within the £30,000.00 “tax free” threshold payment.

The rules also now state that an employee who is a UK Tax Payer who works abroad will also now be subject to such deductions thereby ending the old Foreign Service Relief provisions.

The new rules also make it clear that any payment made to a departing employee representing injury to feelings will also be subject to such deductions except where the injury amounts to a psychiatric injury or any other recognised medical condition.

It will be even more important now to ensure the correct Tax deductions are made.

HMRC can recover unpaid Tax and National Insurance as well as penalties and interest from employers.

I would urge therefore all employers to take advice before discussing any such payments with a departing employee, particularly before any such payment is made.