Favourable tax treatment on termination payments acknowledges that leaving employment can be a difficult and uncertain time for employees. At present, in certain circumstances, employees can receive up to £30,000 free of tax and National Insurance contributions on termination of employment. In some circumstances, for example where the employee’s employment includes certain types of foreign service, it may be possible for more than £30,000 to be paid free of tax. Other payments fall to be taxed in the same way as salary.

The circumstances in which a payment may qualify for favourable tax treatment are complicated and often misunderstood. For example, payments in respect of a contractual notice period that is not worked will sometimes be subject to tax (if there is a contractual right to make a payment in lieu of notice (PILON) and otherwise will not need to be taxed. The rules relating to tax on termination payments are not mirrored in the rules for National Insurance contributions on the same payments, and this adds to the confusion.

The Office of Tax Simplification has identified tax treatment of termination payments as a very complex area. The government is consulting on simplifying the tax and National Insurance treatment of termination payments.


The main proposed changes are:

  • Removal of the distinction between the tax and National Insurance contributions treatment of contractual and non-contractual payments, including notice payments.
  • Alignment of income tax and national insurance contributions, so that both or neither apply to a payment.
  • Removal of the current £30,000 tax exemption and replacement with a new exemption which increases in proportion with the number of years of service the employee has completed with the same employer (or an associated employer). There would be no exemption for those with under two years’ service. The proposed level of the exemption is not specified, but it would appear the government has something lower than £30,000 in mind. The consultation document includes an illustrative example in which the exemption is set at £6,000 after two years’ service, with an additional £1,000 for each additional year’s service.
  • Possibly, restricting the tax-free exemption to redundancy situations (including voluntary redundancy). Payments in connection with compensation for unfair or wrongful dismissal may also be afforded favourable tax treatment.
  • A range of anti-avoidance provisions, including loss of the tax free exemption if the employee is re-engaged in a similar job by the same employer (or an associated employer) within 12 months. Also, excluding payments made through salary sacrifice or flexible benefit schemes from any exemption.
  • Retaining an exemption for termination of employment in circumstances of illness or disability - albeit with modifications.
  • Possible removal of the current foreign service exemption.
  • Possible removal of other exemptions (not HM Forces payments) in the name of simplification. This includes favourable tax treatment on legal fees an employee incurs in connection with termination of employment.
  • Not imposing tax or national insurance deductions on any payment connected with discrimination that has been awarded by a tribunal.


These proposals represent radical reforms of tax treatments which, whilst quirky and confusing, have largely remained consistently quirky and confusing for many years.

Simplification should be helpful for all parties. Greater clarity should mean that employers and employees alike will spend less time, and incur lower professional fees, dealing with tax considerations.

However, those with under two years’ service lose out. Many more employees lose out, if the thresholds for exemption are lowered. It is also not difficult to predict the new areas for tax-related argument in a termination package negotiation or settlement agreement draft. The winners, however, would be those with long service who receive relatively low termination payments which include pay in lieu of notice, particularly where there is a contractual PILON.

Employers committed to contractual enhanced redundancy arrangements should check the wording of the redundancy payment promise. If it promises that the first £30,000 will be paid free of tax, grossing up may be necessary in order to comply with the contractual promise. If the £30,000 tax-free element is removed, this may be unaffordable.

Employees in a contentious negotiation over termination pay are likely to fight harder to increase their financial cushion against uncertain future income if more of that cushion will be diverted as tax.


The consultation was launched on 24 July 2015, and the closing date for comments is 16 October 2015.


The consultation document suggests that the government will publish details of the consultation responses and expects to make an announcement at Autumn Statement 2015 on any decisions made in the light of those responses.


Anyone may respond to the consultation, but it is particularly focused towards employers, employees and the accountancy profession. For further information visit www.gov.uk.

This article was originally publish in 'Purely Payroll', August 2015