Tax and termination payments

The tax treatment of termination payments is governed by a detailed set of rules that determine how much is taxable and whether National Insurance contributions apply. The structure of a termination package can have a significant impact on the final tax position for both the employee and employer.

There still a number of important exemptions available. Employees do not usually pay tax or National Insurance on employer contributions made into a registered pension scheme as part of a termination package, although tax charges may arise if pension annual allowance limits are exceeded. Legal fees paid directly by an employer to a solicitor in connection with a settlement agreement are also generally exempt.

In addition, payments made because of an employee’s injury, disability or ill health may qualify for exemption where the condition prevents the employee from continuing to carry out their duties.

Employees do not normally pay tax on the first £30,000 of qualifying termination payments. This can include statutory redundancy pay, enhanced redundancy payments and certain non-cash benefits provided after employment ends. Any amount above the £30,000 threshold is generally taxable and may also trigger employer Class 1A NICs.

It should be noted that not all termination payments qualify for the £30,000 exemption. Amounts treated as earnings remain fully taxable and subject to employee and employer National Insurance. This includes payments in lieu of notice (PILONs), gardening leave payments and Post-Employment Notice Pay (PENP).

Tax and termination payments

The tax treatment of termination payments has changed significantly over recent years. The changes have aligned the rules for tax and secondary National Insurance contributions (employer (NICs)) by making an employer liable to pay NICs on termination payments they make to their employees. An employer is required to pay NICs on any part of a termination payment that exceeds the £30,000 threshold.

In addition, all payments in lieu of notice (PILONs) are both taxable and subject to Class 1 NICs. The legislation requires the employer to identify the amount of basic pay that the employee would have received if they had worked their notice period, even if the employee leaves the employment part way through their notice period. The amount is treated as earnings and not subject to the £30,000 Income Tax exemption. All other termination payments are included within the scope of the £30,000 termination payments exemption.

It is expected that any employer NICs due on termination payments will be collected in 'real-time', as part of the employer’s standard weekly or monthly payroll returns and remittances to HMRC.