29 Jul 2013

Taxation of termination payments

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What are termination payments?

Termination payments are severance payments to employees on termination of their employment

They can arise in a number of ways, for example, in connection with:

  • Dismissal or constructive dismissal

  • Redundancy

  • Retirement

  • Departure because of disability

Termination payments must be taxed correctly

  • HM Revenue & Customs (HMRC) can recover unpaid tax, national insurance contributions (NICs), penalties and interest from the business if termination payments are not taxed correctly

  • A business should consider both income tax and NICs

    In addition to employee’s NICs, the business must pay employer’s NICs on payments that constitute earnings from employment

    This can add significantly to the costs of settlement

  • If the business does not deduct tax or NICs from a termination payment it will be generally liable for the tax and NICs not deducted, plus interest and penalties

    A failure to deliver PAYE returns on time (or at all) may lead to more penalties

  • Both the business and its former employee will want the termination payment to be legitimately structured to:
    • reduce the tax liability; and
    • increase the certainty that no future liability will arise

How much of the termination payment is taxable?

How much of a termination payment is taxable will depend on the nature and amount of the payment

Payments fall into a number of categories including:

  • Sums that the employee was contractually entitled to, or were connected with, past or future service: These are generally taxable in full and include:
    • salary payments;
    • contractual bonus or commission;
    • contractual payments in lieu of notice (PILONs); and
    • automatic PILONs

  • Consideration for entering into restrictive covenants

    This is taxable in full


  • Non-contractual payments made as a result of the termination and redundancy

    The first £30,000 is tax-free

    These include:

    • damages for wrongful dismissal and payments on account of damages;
    • compensation for unfair dismissal;
    • compensation for discrimination made in connection with the termination to compensate for financial loss;
    • payments of statutory and non-statutory redundancy; and
    • non-contractual benefits in kind provided on termination


  • Payments where termination results from a disability or from a discrimination claim not connected to the termination

    These are tax-free without limit


  • Share options and share awards

    Employees may be entitled to exercise share options and receive share awards either before or at some point after termination

    The tax and NICs liabilities will depend on a number of factors, including:

    • whether the scheme is HMRC approved;
    • the length of ownership; and
    • the reason for cessation of employment

     A cash cancellation or compensation payment will be fully taxable


  • Employer contributions to registered pension schemes

    These may be made tax free, subject to the annual contribution limit

National Insurance Contributions

NICs are generally payable for all termination payments that the employee is entitled to under their employment contract

HMRC may argue that NICs are payable where there is an established practice of making termination payments, even where there is no express contractual right

Tax-free benefits that can be provided to employees

Provided that payment is made directly to the provider of the service, the following services can be made available to an employee without attracting tax:

  • Legal fees in connection with a compromise agreement

  • Outplacement counselling

  • Re-training

For further information on this topic please do not hesitate to contact me ( Peter Sinding 

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