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.

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.


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      • Neil Largan
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