How to handle termination payments correctly

James Dawson tackles some frequently asked questions on the payments made when you terminate an employee’s contract.

With careful planning, you can save tax and national insurance when you make termination payments, but it’s important to bear a number of different factors in mind. Remember that the first £30,000 of any such payment can, in theory, be made tax free, but there are a number of conditions attached.

What are the current conditions which for the exemption to apply?

Currently, if you have a contractual right to make a payment in lieu of notice (‘PILON’), that payment is subject to income tax and national insurance contributions (‘NICs’).

If there is no PILON clause and the employer grants a termination payment to the employee at the end of the employment, the first £30,000 can be paid tax-free. Any amount above this threshold is taxable, however no NICs are due.

What are the conditions which must be met after 5 April 2018?

From 6 April 2018 all payments in lieu will be taxable. The intention of these reforms is to ensure that the basic pay an employee would have earned had the employee worked his or her notice in full will be subject to tax (any amount above this may benefit from the £30,000 exemption).

The reforms will therefore require employers to identify the amount of basic pay that the employee would have received if they had worked their notice period and to split a termination payment between (1) amounts treated as earnings and (2) amounts which are being paid in true compensation for loss of employment and which may benefit from the £30,000 threshold for tax exemption.

And from April 2019?

Currently, where the exemption is available no National Insurance (NI) will be due on the payment made. However, from April 2019, this rule will change with employer’s NI being payable on the balance over £30,000.

Can some payments qualify for a higher limit?

Yes. Some can even be paid tax free, where the payment relates to injury, disability or death. However, HMRC interpret the exemption for termination on injury or disability very narrowly.

What are the rules about non-cash benefits?

There is a requirement to include the cash equivalent of any non-cash benefits made, for example the provision of a company car. Any non-cash benefits are treated as income in the year in which the benefits are enjoyed.

Does the timing of the payment make a difference?

Where a qualifying termination payment is made to the employee before they leave, the excess over £30,000 is subject to deduction of tax under PAYE under the normal rules. If payments are made to an employee after they leave, and after a P45 has been issued, then the employer must deduct tax under PAYE at the basic rate. The employee is then liable for any additional tax charge on the termination payment received under the self-assessment system.

What planning opportunities do you have?

There are a few possibilities where the termination is to exceed the £30,000, such as:

  • making a contribution towards the employee’s legal fees, which may include, for example, the fees for their solicitor to review a compromise agreement;
  • deferring the tax point – there may be a saving to the employee by spreading the payment over two tax years, where the entitlement to deferred consideration should be specified in the settlement agreement;
  • making a contribution into the employee’s pension fund; and
  • considering whether any element of the payment made could be identified as compensation for discrimination, or injury/disability, which may be tax free.


Given the complex nature of the legislation, it’s always good to seek advice before a termination payment is made, to avoid any potential bear traps. Failure to take reasonable care in analysing the nature of the payment and describing it in the settlement agreement may result in the parties facing unnecessary or unexpected tax liabilities.