Payments on Termination – General • All payments relating to an employee’s actual employment are taxable and subject to National Insurance contributions under Section 6, Income Tax (Earnings and Pensions) Act 2003 (“the Act”). Such payments will include salary, bonuses, commission, and contractual pay in lieu of notice.

• Payments provided only on termination of employment are generally taxable but not subject to National Insurance contributions under Section 401 of the Act. Such payments include:

o redundancy payments; and

o damages or compensation for wrongful dismissal, unfair dismissal and/or discrimination;

The first £30,000 of any such payment is not chargeable to tax or subject to National Insurance. In order to satisfy the Inland Revenue that Section 401 applies it must be clear that the severance payment is directly associated with termination of employment, rather than the payment being consideration for a variation to the employee’s terms of employment. Tax is deductible at basic rate only on the excess over £30,000 provided that the P45 is issued prior to payment of the severance sum. This is the case irrespective of whether or not the employee is a higher rate tax payer.

• A limited number of payments made on termination are not taxable, including compensation for injury to feelings. A such, these payments should not be included when calculating the value of the termination package for the purposes of the £30,000 exemption.

• If an employee’s employment is to be terminated, but the employee will continue to provide services to the employer (for example under a consultancy agreement), it is still possible for the £30,000 exemption to apply, providing the Inland Revenue is satisfied that the former employee’s relationship with the employer post termination is fundamentally different to the role provided during his employment. However, there is a risk that the Inland Revenue will not accept that the payment is genuinely in relation to the termination of employment, and so the exemption will not apply.

• It may be possible for the employee to avoid paying tax on the severance payment where the employer pays the sum directly into an approved pension fund. This is subject to the rules of the scheme and Inland Revenue maximum limits, and professional pensions advice should be sought before making such payments.


• Where an employee has a contractual right to be paid in lieu of notice on termination, such payment is chargeable to tax. The situation is the same where an employer pays in lieu of notice as a matter of course, even if the employee’s contract does not expressly state an entitlement to payment in lieu of notice. Payment in lieu of notice where the employment contract that does not include a PILON clause (and the employer does not typically pay in lieu of notice) will be treated as damages for breach of contract and, as such, can be counted towards the Section 401 £30,000 exemption.

• Discretionary payments in lieu of notice can fall within the £30,000 exemption if the employer can produce evidence that it has exercised its discretion not to pay in lieu in accordance with a PILON clause in the contract. In such circumstances, it will be deemed that the employer has chosen to dismiss the employee without notice and without making the contractual PILON, and the termination payment is treated as damages for wrongful dismissal. The Inland Revenue will have to be satisfied that the discretion has been properly exercised and the employer has not merely sought to help the employee take advantage of the tax concession. If the sum paid by the employer is exactly the same as the payment that the employee would have received had the PILON been exercised, the Inland Revenue may consider the payment to be taxable. Accordingly, an employer should consider making a reduction to the payment in lieu to take account of the employee’s ability to mitigate his position, and/or a reduction for accelerated receipt, both of which will be indicative that the PILON has not been exercised. However, where the employer elects not to invoke the PILON clause, it should note that because the contract will have been breached and brought to an end, any post-termination restrictions will cease to be binding on the employee.

Restrictive Covenants

• Any payment in consideration for the continuation of restrictive covenants (where there is doubt as to the enforceability of the original covenants), or for new post-termination restrictions must be taxed separately in full under section 225 of the Act and is subject to National Insurance contributions.

Legal Fees

• Payment of the employee’s legal fees is exempt from tax provided that a number of Inland Revenue conditions are met. The contribution, set out as a term of the compromise agreement, must be in respect of fees incurred solely in connection with the termination of employment, and be paid directly to the employee’s solicitor.

• Where the employer is unwilling to contribute to all of the employee’s incurred legal costs, and the employee is receiving a settlement sum which exceeds the £30,000 exemption, the employer may agree to cover all of the legal costs under the compromise agreement provided that the balance is re-apportioned from the agreed settlement payment. Thus the employer is not paying any more money, but the employee is taking the benefit of the tax concession.

Drafting Issues

• If the £30,000 exemption is wrongly applied, the Inland Revenue will seek to recover the tax from the employer. The employer may also be liable for charges and interest. The employer may, therefore, seek an indemnity from the employee that it will be responsible for such payments.

• The employer may seek in the compromise agreement to reserve its right to claw back the termination payment from the employee if the employee brings proceedings against the employer after entering into the compromise agreement. There is a risk, however, that such a clause may be deemed unenforceable by a court or tribunal as a penalty.

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