From 5 April 2011 PAYE will have to be operated on taxable termination payments at the highest marginal rate of income tax of the recipient. In a separate development, the Court of Appeal held that employers are not obliged to structure termination payments tax efficiently.

PAYE on Termination Payments

At present, employers that make taxable payments to former employees following the cessation of employment are required to operate PAYE at the basic rate of 20% using the "BR" code.

Consequently termination agreements are usually structured so payments are made after the issue of the P45 to ensure the recipient benefits from the cash-flow advantage of paying tax only at the basic rate. Any additional tax is required to be settled by the former employee through self-assessment.

HMRC have announced the PAYE regulations will be amended, with effect from 6 April 2011, so employers are required to operate PAYE on taxable payments made following cessation of employment at the highest tax marginal rate of the recipient.

Employers will be required to use an "OT" PAYE code to ensure tax is withheld at 20%, 40% or 50% as appropriate.

Court of Appeal Case of Norman v Yellow Pages Sales

In a separate development, the Court of Appeal issued judgement in a case involving a termination payment for £53,000 (Norman v Yellow Pages Sales). The employer operated PAYE at the basic rate on the payment in excess of £30,000. The former employee claimed the employer had a duty to apportion some of the payment as compensation for injury to feelings in connection with her discrimination claim so that element would not be taxable.

The Court of Appeal disagreed finding there is no such duty on the employer, it was up to the former employee to argue with HMRC as to why no tax (or less tax) is due on the payment.


Although Norman v Yellow Pages Sales is helpful to employers, both sides usually seek to structure termination payments tax efficiently (indeed tax savings can often bridge the gap between the parties in difficult cases).

The changes to the PAYE regulations are unlikely to alter the way termination payments are structured. It will, in our view, still generally make sense to make these payments after cessation of employment to help demonstrate they are "ex-gratia" as opposed to general earnings.

The change will also have an impact on the withholding obligations of employers in respect of share option and share award gains which arise after an employee has ceased employment.