May 9, 2018

The changes to tax treatment of termination payments

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The changes to tax treatment of termination payments

From 6th April 2018, new rules on how termination payments are to be treated with regards to tax came into force.  These new rules have tightened the tax treatment of payments made, whether these are made within a settlement agreement or not.  Some of the most common have been highlighted below but obtaining advice in respect of termination payments should be taken to ensure the tax treatment is applied correctly.

Where such payments are made, it is now important to assess the basis on which the payments are made and the factual background in order to assess whether tax is payable or not.  The statute applicable in relation to this matter is the Income Tax (Earnings and Pensions) Act 2003 (ITEPA).

HMRC recommends that the following questions be addressed, in the following order:

  1. Does the payment fall within the category of general earnings (or is it a benefit of the employment) under Parts 2 to 5 of ITEPA 2003?
  2. If not, is the payment for a restrictive covenant taxable under 225& 226 of ITEPA 2003?
  3. If not, and no other income tax charge applies (for example, compensation for loss of a share option), is the payment taxable under s. 401- 416  of ITEPA 2003?

This follows the order of priority in which the statutory provisions are applied.

Sections 401 – 416 of ITEPA 2003 act as charging provisions for termination payments where no other charging provision applies. As a result, they will only apply if the payments are not otherwise taxable under s. 62 of ITEPA 2003 or any other provision such as those above.  It covers payments and other benefits received in connection with the termination of employment or a variation in the duties or earnings from employment.

  1. 401 is widely drafted and is designed to catch all payments and benefits that are not earnings. Therefore, rarely will ex gratiapayments (in excess of £30,000) escape liability to taxation altogether. The first £30,000 of payments that fall within section 401 and is not treated as “post-employment notice pay” (PENP) is exempt from tax and any excess will be subject to income tax in the normal way.


NICs are generally payable in respect of all termination payments to which the employee is entitled under the contract of employment. HMRC may also argue that NICs are payable where there is an automatic practice of making termination payments, even where there is no express contractual right.

Payments within s. 401 – 416 of ITEPA 2003 are not “earnings” for NICs purposes and are therefore not generally liable to NICs, but may be brought into charge by express provisions.

The different types of payments

HMRC continues to scrutinise carefully payments made on the termination of employment where s. 401 – 416 of ITEPA 2003 are being relied on. Careful analysis of the nature of a termination payment is crucial therefore, as this will determine its tax treatment.

Contractual severance payments (other than payments in lieu)

Most contractual payments are liable to income tax under s.62 of ITEPA 2003 and to NICs. This is the case even if the payment is intended to compensate for loss of future earnings.

HMRC also treats payments made on termination as subject to tax under section 62 of ITEPA 2003 if there is an established custom of making these payments.

Benefits in kind

Severance packages often include benefits in kind, such as a company car. Other than specific exclusions such as outplacement costs, the benefits are valued in the same way as benefits provided during. Non-cash benefits will be valued at an amount equal to the cash equivalent of the benefit.

Share options and share awards

Employees may be entitled to exercise share options and/or receive share awards either before or at some point after termination.  The terms of the relevant employee share scheme will govern any right of exercise or entitlement to receive shares. Therefore, the reason for the termination will need to be clearly identified for the purposes of dealing correctly with the employee’s share scheme entitlements.  However, there are many factors which need careful consideration as in relation to shares so individual advice on this is crucial.

Payments in lieu of notice from April 2018

From 6 April 2018, all payments in lieu of notice (PILON) paid on termination of employment will be classed as earnings. Payments will therefore be subject to tax and class 1 NICs.  The tax treatment no longer depends on whether there is a contractual PILON in the contract of employment or not and settlement agreements will clearly need to show which portion of the payment is a PILON.

What is a relevant termination award?

A relevant termination award (RTA) is a termination award excluding specified payments.

A termination award is defined as a payment or other benefit received directly or indirectly in consideration of in consequence of or otherwise in connection with the termination of a person’s employment.  Accordingly, payments or other benefits chargeable to tax apart (such as restrictive covenants and contractual PILONs for example) are not termination awards.

The excluded payments are statutory redundancy pay and approved contractual pay (to the extent that it does not exceed the statutory redundancy pay).   So, these automatically benefit from the £30,000 exemption.

This means that non-statutory redundancy pay is a termination award and, in contrast with statutory redundancy pay is not excluded.

Therefore, non-statutory redundancy is a “relevant termination award” and will no longer automatically fall within the £30,000 exemption.

What must be taxed as earnings?

The slice of the relevant termination award (RTA) that must be treated as earnings under s. 402B is:

  • The entire RTA if “post-employment notice pay” (PENP) is equal to or more than the RTA.
  • PENP, if it is less than the RTA but is not nil.

If PENP is a negative amount, it is treated as nil.

Pay in Lieu of Notice (PILON)

There are a number of different types of PILON’s used and, for the most part, HMRC will consider them all as taxable.  Indeed, there is numerous case law just on this topic.  Certainly contractual and implied PILON’s are usually taxable but PILON’s paid as damages for loss of notice may fall within s. 401 of ITEPA 2003 and can therefore be paid tax free (up to the £30,000 limit).   However, HMRC will look carefully at the reason for the PILON payment to ensure it falls within the definition of damages rather than another sort of PILON so a careful analysis of this is important.  Advice should be taken in each circumstance.


Statutory and enhanced redundancy payments fall within s. 401-416 of ITEPA 2003, provided they are paid genuinely on account of redundancy. No NICs are payable.

Payments which are, in fact, a terminal bonus paid in recognition of an employee’s services during the notice period or during the employment generally will be taxable s. 62 and subject to NICs.

The employer should take care if the employee is retiring, or where some of the redundancy payment will be conditional on staying until a specified date, because HMRC could seek to tax such payments as employment income.

New PENP rules from 6 April 2018

As noted above, statutory redundancy pay and approved contractual pay (to the extent that it does not exceed statutory redundancy pay) automatically benefit from the £30,000 exemption.

Non-statutory redundancy will no longer automatically fall within the £30,000 exemption.

For any queries in relation to the above, or termination payments generally, please contact Ilinca Mardarescu.