The tax treatment of termination payments made to departing employees is a relatively complicated area, with errors or disagreements with HMRC easily occurring and mistakes proving expensive. However, the rewards of correct categorisation can be high: currently, non-contractual termination payments are free of NICs and are only taxable to the extent they are more than £30,000, and complete exemption is possible in some cases. Last year, the Office of Tax Simplification (OTS) concluded in its report on employee benefits and expenses that the current system of taxing termination payments was complex, unfair and led to scope for avoidance. 

Options for reform of £30,000 exemption

The following options for reform are considered in the Government consultation document published in July this year:

  • Blanket exemption – Whilst a blanket tax exemption for the first £30,000 of all termination payments would be simple and easy to administer, both the OTS and the Government consider this option to be financially unsustainable for the Government.
  • Exemption linked to statutory redundancy – this was the OTS recommendation, although this option would remove many of the avoidance opportunities the Government is looking to tackle, the Government does not intend to take this option forward due to the large groups of workers who do not qualify for statutory redundancy e.g. employee shareholders, parliamentary staff and civil servants.
  • Exemption linked to statutory or voluntary redundancy payments based on length of service – This is the Government’s preferred option, and would be calculated according to the number of years of service the employee has completed, but would only be available to employees who have completed at least two years of service. Years of service with the same employer, associated employers or following a TUPE transfer would be counted. Whether or not the payment was contractual or not would no longer matter. The amount of any cap is not specifically mentioned, although it is clear that a cap will be imposed. Some reorganisations can result in dismissals which fall short of the statutory definition of redundancy - often categorised as being for the potentially fair statutory reason of “some other substantial reason (SOSR)”. The dividing line between redundancy and SOSR dismissals can be narrow and this point may well feature in the consultation responses as it is difficult to see why the latter should automatically be excluded.

Other exemptions

The Government is also considering other exemptions which remove the liability to income tax on termination of employment. The consultation document notes that removing all of the existing exemptions would be the simplest approach. However, the Government proposes to retain certain exemptions for injury or disability and payments to the Armed Forces, but is minded to remove the current tax exemption for termination payments relating to working overseas.  On the plus side, if the statutory or voluntary redundancy payments exemption is adopted, the Government proposes to create two new categories of exemption:

  • compensation for unfair or wrongful dismissal; and
  • compensation for loss of future earnings following discrimination.

There will be an overall cap, although the consultation document does not set out the proposed level of this.

One issue not addressed in the consultation is whether share-related remuneration received on termination is capable of falling within the terms of any exemption. Currently it is not able to benefit from the termination payment exemptions at all.


The Government is also proposing to align the income tax and NICs treatment of termination payments, with the current total NICs exemption in respect of ex-gratia termination payments being abolished. While this is simpler and accords with a general Government consultation to align employment income and NICs, it will clearly prove more costly for employers and employees alike.

The future

At this stage it is difficult to predict how tax law will change. The overall result is a very confusing set of proposals which appear to end up with the possibility of more rather than fewer exemptions which suggests the potential for greater rather than less confusion. The removal of the somewhat artificial historical distinction between the taxation treatment of contractual and non-contractual entitlements is in principle welcome but the principal aim appears to be to ensure no overall decline in tax receipts as much as the creation of an easier-to-administer system.

The deadline for responses to the consultation is 16 October 2015, with any Government announcement of action being taken scheduled to be made in December.