Termination Payments: Understanding the potential Tax implications

Giving consideration to termination payments can be a challenging task, and understandably daunting for both employers and employees.

It is understandable, therefore, that when trying to reach a solution, assumptions may sometimes be made about the tax consequences (e.g. it will qualify for tax exemption or won’t it?), or in some cases, these consequences are only considered once the ink has dried.

Allowing this to happen can invite unexpected additional costs, alongside other problems which might otherwise have been avoided, showing the importance of planning ahead.

The tax angle

The first point to keep in mind is that, with the exception of statutory redundancy pay, any other payments made, or benefits provided, in connection with the loss of employment have the potential to incur a charge to Income tax and National Insurance Contributions.

Despite this, there is often a misconception, particularly among employees, that the first £30,000 of any termination package will automatically be tax-free. That would, however, potentially be to overlook that the precise tax treatment attached to each element of a termination package needs to be considered to avoid unexpected liabilities.

Not all payments made on termination qualify for this exemption.

Payments that are rooted in the employment contract or are otherwise a reward for work done are treated as earnings and remain fully subject to Income Tax and NICs in the normal way. Before applying the exemption, it is also necessary to consider whether a payment falls within other tax rules that take priority, including those relating to restrictive covenants, or payments connected with retirement or death. As a result, determining the correct tax treatment requires a clear understanding of both the nature of the payment and the circumstances in which it is being made.

Post Employment Notice Pay (PENP): A further consideration

Once the other legislative provisions have been considered, a further layer of complexity arises in the form of the Post-Employment Notice Pay (PENP) rules, introduced in 2018. These rules are designed to ensure that amounts relating to an employee’s notice period are taxed as earnings, even where the payment is not explicitly described as a payment in lieu of notice.  

As a result, some payments that might otherwise have benefited from the £30,000 exemption can instead become subject to Income Tax and Class 1 National Insurance Contributions. While the principle of PENP may seem straightforward at first glance, the legislation applies a prescribed statutory formula that can produce unexpected outcomes. It can result in amounts originally intended for another purpose being reclassified and taxed as earnings.  

It is therefore important to consider the PENP calculation in every termination payment case (other than where the payment consists solely of statutory redundancy pay). 

Particular care is needed where employees participate in salary sacrifice arrangements, or where such arrangements form part of the termination package, as these can significantly affect the PENP calculation and lead to unexpected tax consequences.  

Understanding and applying the rules correctly from the outset can help avoid surprises and ensure the correct tax treatment is achieved. 

How we can help 

Termination payment calculations can be more complex than many employers realise, with over 60 separate factors potentially affecting the tax and National Insurance treatment. As a result, important details can easily be overlooked, often leading to issues that are difficult to resolve once an employee has left the business and, in some cases, resulting in employers having to settle additional tax and NIC liabilities directly with HMRC.