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Tax on Termination Payments - The Times They Are A-Changing

Current Legislation

Under current legislation, workers who are paid a termination payment, often via a settlement agreement provided by their employers, can receive genuine ex-gratia compensation for loss of employment up to £30,000 without attracting income tax and National Insurance contributions (NICs).

Confusion has arisen in the past where “other” payments, additional to any compensation payment, are provided to workers as a lump sum with the compensation payment. Such other payments generally take into account a worker’s notice period, bonus, commission and any holiday pay which the worker may contractually be entitled to. HMRC are however clear that any payment which a worker is entitled to under their contract of employment, will attract tax and NICs deductions. It is this type of taxable payment that is often ignored by employers upon termination and one that HMRC are increasingly clamping down on.

The main area of tax avoidance involves notice periods and the presence, or lack of, a payment in lieu of notice (PILON) clause in a contract of employment. Employers and lawyers have been quick to exploit the lack of a PILON clause in a contract of employment to make a payment more attractive to a departing employee, often to smooth through an exit. If there is no PILON clause in a contract of employment, and an employer terminates the employment of a worker with immediate effect, that should technically be a breach of contract. Subject to custom and practice payments, this should then allow any notice pay to be paid as a compensatory payment for breach of contract rather than a contractual payment and so not attract tax or NICs on the first £30,000 of that payment.

Even before the latest review of tax treatment on termination payments, HMRC have been sceptical of PILON payments and often go behind the contract of employment to see if there is a custom and practice in a business of making a PILON.  If there is a custom or practice or an employee has a reasonable expectation of a PILON on exit, HMRC are very likely to seek to claw back any tax and NICs on that payment plus interest and penalties, etc.  This can be an expensive mistake to make.

Proposed changes

Despite an earlier suggestion to change the level of an individual’s tax free annual allowance, the Government have, after consultation, now proposed to keep it at £30,000. A number of proposed changes have, however, been put forward by the Government (undoubtedly to swell Treasury coffers).  They are:

• From April 2018, HMRC propose to treat all contractual and non-contractual PILONS in the same manner. In essence this means that all payments for notice periods will attract tax and NICs irrespective of whether made in breach of contract or not.

• Currently compensation payments in excess of £30,000 attract tax but not NICs. From April 2018 this is proposed to change and employers will be expected to pay Employers' NICs on any payment above the £30,000 threshold. The current rate of Employers’ NICs is currently payable at a rate of up to 13.8%. This will be a big financial burden for employers and one that will need to be factored in during consideration of any financial compensation payable on exit in the future. The worker NIC exemption will not be changed.

• Any compensation payment attributable to injury to feelings will be taxable unless a recognised medical condition has arisen owing to the treatment of a worker by an employer.

• The Foreign Service Exemption, which eliminates or currently reduces tax on termination payments where a worker has worked outside of the UK for 75% of the last 20 years, will be removed with limited exceptions.

What should you be doing now?

During recruitment negotiations with a senior worker, it is not unusual for a business to accept a request to leave out a PILON clause from a contract of employment to allow for any termination payment to be paid free of tax. Should the current proposals go through, there will now be very little business sense in not having a PILON clause in a worker’s contract of employment.

We would recommend that PILON clauses are included in all contracts of employment for workers if the above proposals come into force. Having a PILON clause benefits an employer in a number of ways including allowing for a quick removal of a worker without risking a breach of contract claim. Employers should also remember that should they breach a worker’s contract (by paying in lieu of notice when there is no PILON clause in a contract), they may render any post termination restrictions in that contract void, allowing a worker to potentially join a rival or set up in competition immediately following termination.

What does this mean for you or your business?

Whilst the introduction of the above changes are not due until April 2018 (if approved by Parliament), employers should be aware of the financial burden the change in the law will have on their business. Should your business be in the mind-set of regularly entering into termination payments or settlement agreements exceeding the £30,000 threshold or of making tax free PILON payments, an increased tax obligation should be factored into annual budgets and to settlement negotiations with staff.


These notes have been prepared for the purpose of an article only. They should not be regarded as a substitute for taking legal advice.


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