The government is reviewing the rules covering the tax treatment of termination payments. At present, the first £30,000 of certain termination payments is exempt from income tax and NICs. However, this is not a straightforward exemption and to apply, the payment must be paid directly or indirectly in consideration or consequence of – or otherwise in connection with – the termination of a person’s employment, or a change in their duties or earnings. Often, the defining issue is whether or not the payment amounts to compensation for a breach or whether it is a payment referencing a contractual entitlement. For instance, a payment described as being ‘pay in lieu of notice’ (PILON) will always be taxable if there is an express right in the contract of employment to pay in lieu, but otherwise would be dependent on whether or not it is a payment referenced to the notice period or compensation payable because no notice was given.

The government is of the view that the current regime is overly complicated, and having commissioned a report from the Office of Taxation Simplification a number of proposals have been consulted on, namely:

  • Removing the existing distinction between contractual and non-contractual termination payments, making all payments made on termination taxable, unless one of the new exemptions apply. Therefore, some contractual PILONs which do not currently benefit from a tax exemption may do so in the future, depending on the employee’s years of service and any caps imposed.
  • Replacing the current £30,000 tax exemption with an exemption determined by the employee’s years of service. This, though, may be limited to terminations connected to redundancy.
  • Introducing new exemptions for: compensation for unfair or wrongful dismissal, whether determined by a tribunal or as agreed between the individual and employer, and any payment connected with discrimination that has been awarded by a tribunal.

Existing exemptions for injury or disability and the armed forces would remain, and the current Foreign Service exemption would be replaced with territorial limits for termination payments.

The government is currently collating responses to the consultation, and intends to publish a summary of responses and make an announcement on any decisions made in light of them as part of the 2015 Autumn Statement, to be published on 25 November 2015. We do not know exactly what changes will be made but it seems likely that the tax treatment of ex-gratia payments will be less generous than is currently the case. Employers negotiating the exit of staff will be affected by this because if they cannot offer as much tax free, employees will look for higher settlements.

In the meantime, employers drawing up settlement agreements with departing employees will want to ensure that they secure an indemnity from the employee in relation to the tax treatment of the termination payment. Employers should consider whether or not, if the timing is marginal, they wish to accelerate the termination date to before 25 November 2015 to ensure that it takes place before any forthcoming changes.


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Paul Seath

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Posted on 27/10/2015 in Legal Updates

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