Termination payments, often arising at the time of retirement or dismissal, can include compensation for loss of office, redundancy payments, damages for dismissal, payments in lieu of notice, and similar payments. The tax treatment of these payments depends on their nature and can be fully taxable, partially taxable, or fully exempt.
Fully Taxable Payments
Termination payments are fully taxable when they are tied to services performed under an employment contract. Examples include:
Rewards for services performed: Payments resembling salaries or bonuses, such as golden handshakes.
Contractual payments: Payments explicitly stated in the employment contract.
Expected payments: Even if not stated in the contract, payments reasonably expected by the employee (e.g., longstanding company practices) are fully taxable.
Garden leave payments: Payments made during garden leave are also fully taxable.
Fully Exempt Payments
Certain termination payments are completely exempt from tax, such as:
Death, injury, or disability payments: Payments made upon the employee's death or due to injury/disability are tax-free.
Pension contributions: Employer contributions to a registered pension scheme as part of the termination package are tax-free.
Partially Taxable Payments
Under ITEPA 2003 s.403(1), some termination payments benefit from a £30,000 tax exemption. Any amount exceeding this limit is subject to income tax but is exempt from employee National Insurance Contributions (NIC). However, employers must pay Class 1A NIC on the excess.
Qualifying Payments for the £30,000 Exemption:
Redundancy payments: Both statutory and non-statutory redundancy payments qualify.
Statutory redundancy: A fixed amount calculated based on years of service as required by employment law.
Non-statutory redundancy: Additional payments made as further compensation.
Ex gratia payments: Payments made as a gesture of goodwill or moral obligation rather than a legal requirement.
Other Exempt Payments and Benefits
Certain benefits provided at termination are also exempt from tax:
Legal costs: Payments made directly to an employee’s lawyer for dispute resolution under a compromise agreement (provided the agreement is out of court).
Outplacement counselling: Professional services, including travel costs, to help an employee adjust after redundancy or secure a new job.
Retraining courses: Costs covered by the employer for retraining aimed at equipping the employee with new skills for future employment or self-employment.
Speak to an Expert
Whether you're an employer navigating the complexities of termination payments or an employee seeking clarity on tax implications, our tax team is here to help. Contact us today for expert advice tailored to your situation.
Authored by: London Tax Team
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