We are often asked to advise on confidential pre-termination negotiations, or without prejudice negotiations to resolve an existing dispute, where the school wishes to negotiate the exit of a member of staff under a settlement agreement.

During recent weeks, several schools have requested clarification about new rules concerning the taxation of the termination payments set out in such agreements.

Old Rules

In the case of an employee whose contract provided for payment in lieu of all or part of the notice period, the payment in lieu of notice ("PILON") would be a contractual payment, attracting income tax and National Insurance deductions because it qualified as 'earnings'.

Previously, it had been possible to make a PILON to a departing employee, with the possibility paying the PILON free of tax, where there is no contractual power reserved by the school in the contract of employment to do so. In the absence of a contractual term empowering the school to make such PILON, the curtailment of the employee's notice entitlement represents a breach of contract, so that the PILON could be characterised as 'compensation' for breach of contractual notice rights, and could thereby be paid gross.

This was a helpful bargaining tool where the school could, in effect, place more money in a departing employee's pocket, at no extra cost to the school, making it slightly easier to achieve the school's desired outcome.

New rules

Since 6 April 2018, the rules governing the taxation of termination payments have changed. The government has introduced a series of changes to 'clarify and tighten' the tax treatment of termination payments.

One of the main aims of the strategy, among others, was to require employers to subject an amount equivalent to the departing employee's basic pay for any periods of unserved notice to:

  • tax (pursuant to Section 5 Finance (No.2) Act 2017); and
  • class 1 NICs (pursuant to the Social Security (Contributions) (Amendment No. 2) Regulations 2018).
  • The DfE is asking for views as to how it may improve the section dealing with online safety.

The effect is that it is no longer possible to pay the PILON without deductions, which means that settlements may be slightly more costly for the school.

It is critical to ensure that payments are properly separated in the drafting of the settlement agreement. For example, a single lump sum payment, that does not separate out its constituent parts (for example PILON and compensation), under the new rules, is likely to be taxed in its entirety. Genuine compensation payments should be clearly separated and identified.

The above is a brief summary of some of the most common queries which are arising under the new regime. There is greater complexity where other entitlements come into consideration, for example in connection with payment of contractual enhanced redundancy or maternity benefits upon termination.

Moving forward, schools should ensure they are crystal clear on the tax treatment of all elements of termination payments in order to avoid unwelcome tax/NI liability later on.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.