Practical guide: Dealing with termination payments correctly

Default position

The general rule is that all income received in relation to an employment is subject to tax and NI via PAYE. However, there are a number of exemptions, or partial exemptions, to be aware of.

The company has indicated that they are aware that there is a £30,000 exemption for termination payments. However,  this doesn’t apply to all payments made in relation to a redundancy.

Breakdown of payments

Termination payments will often include several elements, including:

• for any employee with more than two years’ service, statutory redundancy payments
• where the notice period is not required to be worked in full, pay in lieu of notice (PILON) may be due; and
• the employee may feel they are entitled to damages, be it due to a breach of their contract or due to perceived discrimination against them.

Does another section apply?

Before considering whether the £30,000 partial exemption may apply, consider whether other sections of the Income Tax (Pensions & Earnings) Act 2003 (ITEPA) apply.

Firstly, does the income fall within s.62 and so form part of the normal income of the employee? This would include such items as contractual bonuses and non-contractual, but traditionally made, payments.

Next, check whether the income relates to a restrictive covenant and so fall within s.225 ? If so, this would again be taxed as general earnings.

Restrictive covenants are agreements between the (ex) employee and the employer that restrict the future activities of the individual. This can include preventing them from operating in a specified area for a period. Finally, there are special rules where the employee has died or retired. For the purposes of this article we will assume this is not the case.

S.394 deals with retirement benefit schemes and s.406(a) deals with death.

Any remaining parts of the termination payment are likely to be within s.401(1)(a) and so potentially fall under the £30,000 exemption.

Payments in lieu of notice

On the termination of an employment, the employee is usually entitled to notice. Where this is worked, any income earned for the period will be subject to tax and NI under PAYE as usual. However, where the notice period is not required to be worked, the employee may receive a PILON.

In the past, a PILON could fall under the £30,000 exemption if it was non-contractual, or not “expected”, i.e. it was a genuine ex gratia payment. However, this changed for 2018/19 and later years. The current position is that PILONs are fully subject to tax and NI.

Working out the taxable award

To calculate the taxable amount, the employer will need to compare the relevant termination award (RTA) with the post-employment notice pay (PENP).

The RTA is the total being paid that falls within s.401(1) , i.e. the total termination payment that does not relate to another section (see above), excluding statutory redundancy payments.

The PENP is the amount of pay the employee would have received had they worked their notice period, excluding any salary sacrifice arrangements.

To work out the PENP, we use the formula ((BP x D)/P) - T where:

BP is the employee’s basic pay in respect of the last pay period ending before the “trigger date”, i.e. the date notice was given or, if no notice was given, the last day of employment.

D is the number of calendar days between the employment ending and the end of the notice period.

P is the number of calendar days in the employee’s last pay period.

T is broadly any termination payment already subject to tax as general earnings.

Several things are excluded from being included in T, e.g. payment in respect of holiday entitlement. Refer to EIM13896.

The need to calculate PENP revolves around the requirement to offer a PILON. It has become commonplace in recent years for employers to remove PILON clauses from contracts, on the basis that if they then ask someone to leave without working all, or some, of their statutory notice it would be a breach of contract for which damages could be paid. Damages qualify as a relevant termination award and would be tax free up to £30,000 and completely NI free. Any contractual PILON always has to be fully subject to tax and NI.

If the employee has worked all their notice or been on paid garden leave, then there is no PENP to calculate. If any contractual PILON is due to be paid, the PENP must be calculated, as the formula in the legislation means the answer may be higher than the contractual PILON. A higher amount could therefore be subject to tax and NI depending if there are any other RTAs to be paid.

If the PENP is higher than the RTA, the full RTA is treated as employment income and tax and NI are deducted via PAYE. If the PENP is lower, the PENP is taxed as employment income subject to tax and NI with any remainder falling within the £30,000 exemption. Let’s look at how to apply this to our company’s employees.

Worked example

An employee earning £36,000 per annum had their employment terminated on 30 June 2022. They were entitled to three months’ notice but there was no contractual provision for a PILON. No notice was worked.

The employee was paid £33,000 on termination, made up of: £2,000 statutory redundancy, £7,000 enhanced redundancy, £9,000 PILON as damages and a £15,000 ex gratia sum. The RTA is £31,000 (£7,000 enhanced redundancy + £9,000 damages/PILON + £15,000 ex gratia sum).

The PENP calculation is £3,000 basic pay for May (the pay period before termination) x 3 months’ notice)/1 (one month’s pay before termination) so £9,000. There are no taxable payments due so £9,000 must be taxed and the rest of the termination payments can be subject to the £30,000 exemption. The employee would receive: £2,000 statutory redundancy tax free plus £22,000 related to the enhanced redundancy and the ex gratia payment tax free, but the PILON/damages would be subject to tax as it is equal to the PENP.

The companycould also make a payment to the employee’s pension scheme free of tax and NI.

The figures should be declared on the P45 where possible. Any payments made after the issue of the form should be subject to a 0T tax code.