Tax-free Payments on Termination of Employment

There are many common misconceptions about how payments to an employee around the time his employment is terminated are taxed.

One is that the first £30,000 of such a payment always is tax-free.  It can be, but only in certain circumstances.

Another is that HMRC will attack any attempt to make a tax-free termination payment, so the tax should be always be paid.  HMRC often do scrutinise them, but if the payment is made in the right circumstances and structured properly the first £30,000 of it can be made tax-free.

 Special tax rules about termination payments were introduced many years ago because the tax authorities did not like the growing use of golden handshakes, which at the time escaped tax.  To that extent the special termination payment rules can be thought of as anti-avoidance rules.  A corollary of that is that if the payment is chargeable under any other part of the tax code, it will not be taxed under the special termination payment rules.

Taxpayers often argue that payments be taxed under the special termination payment rules as the first £30,000 of payment under them is generally tax-free.

The payment to a former employee can have several components, including: ex gratia payments, payments in lieu of notice (so-called PILONs), redundancy payments, payments into pension schemes, payments for non-compete assurances and injury to feelings.  It is important to consider carefully for what the payment is made.  Redundancy payments always fall within the special termination payment rules, even if there is a contractual right to them.  Payments not to compete are taxed under a separate, specific tax rule.

A key question an employer should ask itself in making a payment to a former employee is:  does the employee have a contractual right (either in his written contract, the company handbook or an implied agreement) to the payment?  If the answer is yes, then the payment might be taxable as if it were a regular payment of salary (as "general earnings").  If not, it might be taxable under the special termination tax rules.

It is often helpful to ask whether the payment by the employer is a payment of damages relating to the employer's breach of the employment contract.  However, that is not definitive.

The misunderstandings and uncertainties surrounding the taxation of termination payments arise because the question of whether the payment is contractual or not can often only be resolved by detailed legal analysis.  If you have any questions about termination payments please contact Nasim Sharf on 01482 337336, email, or Ed Jenneson on 01482337341, email

Posted on: 31/05/2013

This article is for general guidance only. It provides useful information in a concise form. Action should not be taken without obtaining specific legal advice.

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