As the number of business closures rises, it becomes crucial to consider the legal and tax implications surrounding termination payments for employees. While it is commonly believed that amounts up to £30,000 are tax-free, the reality is more complex, as termination payments often consist of multiple elements. This article aims to shed light on the tax considerations associated with termination payments, highlighting key factors and exemptions.


Elements and Taxability of Termination Payments

Termination payments may comprise various components, such as statutory redundancy payments (tax-free) for employees with over two years of service, and payment in lieu of notice (PILON), which is subject to tax. Additionally, employees may be entitled to damages resulting from contract breaches or perceived discrimination, subject to specific conditions.


Taxable and Non-taxable Portions

To determine the tax-free status of a termination payment, the first consideration is whether any part of the payment is contractual or related to restrictive covenants. Contractual amounts, including bonuses, are subject to normal PAYE taxation. Payments for agreeing to restrict future conduct or activities are also taxed under PAYE. PILON payments are subject to general earnings PAYE, while any remaining portions of the termination payment may fall within the £30,000 exemption.

Payments in Lieu of Notice (PILON)

When notice periods are not worked, the portion of the termination payment relating to a PILON is subject to general earnings PAYE, while the balance falls within the £30,000 exemption. To calculate the taxable amount accurately, the “post-employment notice pay” (PENP) must be compared to the “relevant termination award” (RTA). PENP represents the pay the employee would have received had they worked the notice period, while RTA encompasses the total termination payment excluding statutory redundancy payments.

PENP Calculation

The PENP calculation involves the formula ((BP x D)/P) – T, where:

  • BP represents the employee’s basic pay for the last pay period before the “trigger date” (notice or last day of employment).
  • D is the number of days between the end of employment and the notice period’s completion.
  • P denotes the total days in the employee’s last pay period.
  • T represents the amount taxable as general earnings (excluding accrued holiday pay).


Tax Implications and Relevant Termination Awards

If the PENP exceeds the total RTA, the PENP is capped at the RTA amount, with the remaining balance treated as employment income subject to PAYE tax and National Insurance (NI). If the PENP is lower than the RTA, the amount is taxed as employment income, with any remainder falling within the £30,000 exemption. Tax on the chargeable amount is treated as the highest slice of earnings, surpassing any dividend or savings income.

Alternative Approaches: Damages for Breach of Contract

Some employers exclude the right to a PILON in employment contracts, opting to pay damages for breach of contract instead. Damages qualify as relevant termination awards, being tax-free up to £30,000 and exempt from NI contributions.

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