Understanding the taxation of termination payments is essential when ending an employment relationship, whether through redundancy, settlement, or mutual agreement. Recent changes to the taxation of termination payments have made the rules more complex, and it’s important to know which payments are taxable and which qualify as eligible termination payments for tax relief. Our specialist solicitors in North Yorkshire can guide you through the process.
Termination payments are sums paid to employees when their employment ends. They can arise in several situations, such as dismissal, redundancy, retirement, constructive dismissal, or when an employee leaves due to ill health or disability.
It’s vital that termination payments are taxed correctly, as mistakes can lead to significant financial and legal consequences. If payments are not handled properly, HM Revenue & Customs (HMRC) can recover unpaid tax, National Insurance contributions (NICs), penalties, and interest directly from the business.
Employers should consider both income tax and NICs. In addition to the employee’s NICs, the business is also liable for the employer’s NICs on any payments treated as earnings from employment, which can substantially increase the overall cost of a settlement.
If tax or NICs are not deducted when required, the business is usually responsible for the shortfall, plus any associated interest and penalties. Late or missing PAYE returns may also attract further fines.
Both the business and the departing employee will want the termination payment to be legitimately structured to minimise tax liability and ensure there is no future exposure to additional tax or compliance issues.
The tax treatment of termination payments depends on the nature of each payment:
Contractual payments: Amounts the employee is entitled to under their contract, or linked to past or future service, are fully taxable. These include salary, bonuses, commission, and contractual or automatic payments in lieu of notice (PILONs).
Restrictive covenants: Any payment for agreeing to post-termination restrictions is fully taxable.
Non-contractual or redundancy payments: The first £30,000 is tax-free. This covers damages for wrongful or unfair dismissal, redundancy payments (statutory or otherwise), and compensation for discrimination linked to termination.
Disability or discrimination payments: If termination is due to disability or unrelated discrimination, these payments are tax-free without limit.
Share options and awards: Tax and NIC treatment depends on factors such as whether the scheme is HMRC-approved, how long shares were held, and the reason for termination.
In addition, cash cancellation or compensation payments are fully taxable, while employer contributions to a registered pension scheme can usually be made tax-free, provided they fall within the employee’s annual allowance limits.
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:
The taxation of termination payments can be complex, with different rules applying depending on how and why employment ends. Getting the structure wrong can lead to unexpected tax liabilities for both employers and employees.
Our experienced employment solicitors in North Yorkshire can help you understand your obligations and ensure compliance with HMRC requirements.
Contact our team today for clear, practical advice on the taxation of termination payments and to discuss your situation in confidence.
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