An employer's guide to the taxation of termination payments

Background

Severance payments paid on the termination of employment will almost always attract some element of taxation in relation to all or part of the payment. It is important to understand the principles upon which this taxation is based as HM Revenue and Customs (HMRC) can recover any underpayment of tax, penalties, interest and national insurance contributions from the former employer. Recovery is made under the Income Tax (Pay As You Earn) Regulations 2003. In practice, the HMRC will pursue the employer rather than the employee in these circumstances as the employer is an easier and probably more solvent target.

Severance payments will typically be paid:

• Where there is a failure to give proper notice of termination;
• Where there is a redundancy;
• As compensation for an unfair dismissal or an act of discrimination (in a settlement agreement, for example); and
• As an ex gratia payment on a mutually agreed termination.

Which payments are taxable?

It is important when making a termination payment to define carefully what each element of the payment relates to. Payments that relate to any period worked prior to the termination will be subject to income tax and national insurance in the normal way. This will include payments for accrued but untaken holiday at the date of termination.

HMRC suggests that the following questions be asked in deciding whether a termination payment is taxable and upon what basis:

• Does the payment fall under the heading of general earnings or a benefit in kind under parts 2 and 5 of Income Tax (Earnings and Pensions) Act 2003 (ITEPA)?;
• If not, is the payment for a restrictive covenant taxable under sections 225 and 226 ITEPA?; and
• If not, and no other charge to tax applies (e.g., compensation for loss of a share option), is the payment taxable under sections 401 to 416 ITEPA?

General earnings include:

• Any salary, wage or fee;
• Any gratuity or other incidental benefit for money or moneys worth; and
• Anything that constitutes an emolument of employment.

Sections 401 to 416 cover payments and other benefits received in connection with the termination of employment or a variation in the duties or earnings from employment.

Section 401 is widely drafted and is designed to catch all payments on termination of employment not otherwise taxed. The first £30,000 of payments that are taxable under section 401 are exempt from tax. The excess will be taxed at the appropriate rate. Termination payments above £30k are subject to employer national insurance contributions. Payments in relation to death, injury and disability are exempt from tax under section 406 (see below).

Post-Employment Notice Pay (PENP)

Under previous tax law, only payments in lieu of notice (PILON) that were authorised by the employment contract, or made 'automatically' as a matter of custom and practice, were routinely subject to deductions for income tax and national insurance. Any other payments made to a departing employee in relation to an unworked notice period could generally be made tax free. 

However, following a major change to the law in April 2018, this is no longer the case. Now, all PILONs, whether or not contractual, will be subject to tax and national insurance. 

Whenever a termination payment is made (for example, via a negotiated settlement agreement), a portion of the termination award equivalent to the basic pay the employee would have received had they served their notice in full must, broadly, be treated as earnings and taxable under s402B ITEPA 2003. This is referred to as Post-Employment Notice Pay (PENP). The amount of the termination award to be treated as PENP is worked out using a statutory formula. 

Where an employee has worked all or part of their notice period and has paid tax on their earnings or, for example, has received a contractual PILON payment that has already been taxed, this is accounted for in the formula. Liability for additional tax under the PENP rules will be cancelled out or reduced in these circumstances. 

For further information on working out PENP, please see Post-Employment Notice Pay: Summary Calculation Sheet.

Please note that working out the tax payable on a termination payment is complex. We recommend that you speak to your HR Rely advisor and/or an accountancy or payroll professional. 

Redundancy and retention bonuses

Statutory redundancy payments will be tax free up to £30,000. 

PENP calculations are applied to non-statutory redundancy payments. This means that a portion of a non-statutory redundancy payment may be taxable as earnings (see above). The balance up to £30,000 can generally be paid tax free under sections 401 to 404A of ITEPA 2003. 

In cases of large scale redundancies, it is common for employers to agree to pay a bonus to employees if they do not leave their employment until a specific date or until they have completed a specific task. It is crucial to ensure that any enhanced payment is clearly stated to be an enhanced redundancy payment rather than a bonus for carrying out a particular piece of work or for working until a particular date. This is important because the trigger for the enhanced redundancy payment is the dismissal by reason of redundancy not the completion of a task or remaining in work until a specific date.

If you are intending to pay an enhanced redundancy payment, and have any questions about the appropriate tax treatment, you should discuss this with you HR Rely advisor.

Compensation payments

Compensation for unfair dismissal, discrimination or payments made in settlement of damages claims will not be taxable up to £30,000.

Very broadly speaking, payments relating to injury to feelings in discrimination cases which do not relate to the termination of employment can generally be made tax free. Payments relating to injury to feelings relating to or arising from the termination of employment will generally be subject to tax. The only exception is where the injury in question amounts to a recognised psychiatric or other medical condition. 

When a settlement payment is made, there is no 'scientific' way to work out which injury to feelings payments can be made tax free, and which fall to be taxable. An element of judgement, and often negotiation with an employee's legal representative, will be involved. It is important that any settlement payment is structured proportionately and transparently, and can be explained to HMRC in the event of a challenge. 

In any event, as a general guide, the proportion of a termination payment allocated to an injury to feeling payment should not exceed the guidelines set out in The Chief Constable of West Yorkshire Police v Vento (No2) (2003). These are known as the 'Vento Bands' and are set as follows from April 2022:

• Lower band: £990 to £9,900;
• Mid band: £9,900 to £29,600;
• Upper band: £29,600 to £49,300; and
• Amounts in excess of £49,300 can be awarded in exceptional cases.

Employers may come under pressure during negotiations to allocate as much of the termination payment to injury to feelings, unrelated to dismissal, as possible. HMRC may scrutinise such settlements and if the final apportionment of the payment is entirely different to the way a claim has been previously structured there may be a challenge as to the validity of the apportionment. 

Legal fees

If an employer pays the employee’s legal fees in connection with a severance agreement, there will be no tax liability for this sum, provided that:

• The fees are paid direct to the solicitor;
• The costs are incurred solely in connection with the termination; and
• The payment is made pursuant to a compromise or severance agreement (this includes a COT3 agreement made through ACAS).

Outplacement

This is not taxable if it fulfils the requirements of section 310 ITEPA. The requirements are:

• The counselling is for the purpose of adjusting to the cessation of employment and finding new employment;
• The counselling comprises advice and guidance, training to impart or improve skills providing or making available the use of office facilities and similar equipment;
• The employee has no less than two years’ service; and
• The service is generally available to employees or former employees, or particular classes of them.

Payments for restrictive covenants

Payments in consideration of new restrictive covenants or obligations in relation to confidentiality are subject to tax and national insurance under section 225 and 226 ITEPA.

Writing off loans

Writing off employee loans on termination of employment is taxable and does not have the benefit of the £30,000 exemption. However, no deduction would have to be made by the employer under the PAYE regulations. Instead, the employer will inform the HMRC when submitting a P11D. It will always be preferable for an employee to pay back any loan and receive additional compensation from the employer in these circumstances.

Pension contributions

Termination payments made into a registered pension scheme are generally exempt from tax, and do not use up any of the £30,000 exemption provided that they are:

• Part of an arrangement relating to the termination of the employee’s employment;
• Made in order to provide benefits for the employee in accordance with the rules of the scheme; and
• Not otherwise taxable e.g. as part of a contractual PILON.

There is no liability for national insurance in these circumstances, unless the payment is under a contractual PILON or is otherwise liable for NICs. 

Pensions made on or in anticipation of retirement

This is a complicated area, not least because of the removal of statutory and contractual retirement ages for the majority of employees. The general rule is that any payment made on or in anticipation of an employee’s retirement will be taxable under sections 393 and 394 of ITEPA. These payments will not benefit from the £30,000 exemption.

The HMRC consider it to be a question of fact whether a payment is made on or in anticipation of retirement. They are likely to look at the situation closely where an employee takes his pension very soon after the termination of his employment. In looking at whether the payment is connected with retirement, the HMRC will apply ordinary employment law principles. In the case of a purported redundancy, they will look at the statutory definition of redundancy. An employer in these circumstances will have to demonstrate a clear rationale behind the decision to make a redundancy and provide an explanation as to how the termination payment was calculated.

If an employee is intending to retire after his employment is terminated by reason of redundancy, advice should be sought.

Death, injury and disability

A payment made on account of a disability can be made without deduction of tax or national insurance under section 406. To qualify for this exemption, two facts must be established:

• That the employee involved is disabled, i.e., that there is a total or partial impairment in the employee’s ability to perform the functions or duties of his employment. This test is objective rather than subjective; and
• The individual making the payment did so not merely in connection with the termination of the employment but also on account of the disability.  This is a subjective rather than an objective test (Horner v Hasted (Inspector of Taxes) (1995)).

HMRC may take a more restrictive view and consider that the payment must be made solely on account of the disability. If the payment is expressed as being on account of the employee’s potential employment claims, the HMRC view is that this is taxable as it is not solely on account of disability. This appears to be their view even if the disability has given rise to the employment claims. It is therefore prudent to separate out payments for disability from those relating to settling potential claims. There is no limit to the sums that can be covered by this exemption, however, the best practice is to seek advance clearance from the HMRC before making this type of payment. Any request for advanced clearance will require to be supported by medical evidence.

Calculation of tax

Under previous tax law, a severance payment made after both the termination of employment and the issuing of a P45 would be subject to the deduction of basic rate tax only. The HMRC would seek any further tax payments from the employee.

However, now the situation is that if a severance payment is made after the termination of employment and after the issuing of a P45, the employer must deduct tax at the applicable rate as if the employee had no personal tax allowances available.

Payments which have the benefit of the £30,000 exemption under section 401ITEPA do not have to be included in a P45. If the termination payment is in excess of £30,000, how it is treated on the P45 depends on when the payment is made. If it is paid before termination or before the issue of a P45, it should be included in the P45 and the employer should write to the HMRC informing them of the amount and the date of the payment. If the payment is made after the termination of employment and the issuing of a P45, the employer should not issue a new P45 and should write to HMRC informing them of the amount of the lump sum, the date it was paid and the amount of tax that was deducted.

This is a complicated area of the law. This guide is only an outline of the relevant law and advice should be sought before entering into any severance or settlement agreement which might give rise to tax liabilities.