Termination payments in a nutshell
Termination payments are payments made to an employee in relation to the termination or loss of their employment. Most often these relate to:
- redundancy – either statutory redundancy pay, or enhanced redundancy pay where an employer chooses to pay at a higher rate
- Settlement agreements – previously known as compromise agreements, these are agreements where both parties agree to end the employment with certain contractual conditions and with a payment from the employer to the employee
Termination payments may consist of cash or benefits. The tax treatment varies according to the component parts of the payment and depends on the circumstances, purpose and value of the payment. A termination payment may include taxable, partially taxable and exempt elements.
What might be included in a termination payment?
The following are examples of payments that might be make up a termination payment:
- amounts received under a settlement agreement (which is an agreement between the employee and employer to end the employment contract)
- compensation for loss of office (often dealt with under a settlement agreement)
- damages for breach of contract
- redundancy payments (both statutory and non statutory)
- payments on the death of an employee
- payments made on injury/disability of the employee affecting their ability to do the job
- benefits such as transfer of ownership of a company car, continuing private medical coverage
- payments into a pension scheme
What is Post-Employment Notice Pay (PENP)?
For payments relating to terminations on or after 6 April 2018, all payments are treated broadly as if the contractual notice period was worked and will be subject to tax and Class 1 NIC in full.
The value is called the Post-Employment Notice Pay (PENP) which has a specific legislative definition and calculation mimicking the value of the contractual notice.
Is there an exemption for the first £30,000 of a termination payment?
There is an exemption, but this applies only to cash and payments in connection with the termination of employment that are not taxable elsewhere in the legislation. It is therefore important to establish whether that is the reason for the payment.
Any PENP, therefore, is not included in the value to which this partial exemption applies.
Any amounts above the £30,000 are subject to both tax and Class 1A NIC. For termination payments, the Class 1A NIC is paid via RTI and not as part of the P11D process.
Which type of payment are subject to the £30,000 exemption?
This includes payments specifically paid in relation to the loss of the employment such as compensation for loss of office, any sort of redundancy payment, damages for breach of contract resulting in the termination of employment all being examples. This can be a technical area to assess.
How are non-cash benefits valued?
The amount of the benefit is the greater of:
- the amount that would be chargeable as earnings under (which is the money’s worth if the benefit were sold)
- the cash equivalent found using the normal rules of the benefits code – please see our commentary on benefits for more on this
How are termination payments reported?
If the termination package contains no benefits, then the cash payment will be recorded on the Full Payment Submission (FPS) through Real Time Information and no separate report to HMRC is needed.
If the total value of a termination package that includes non-cash benefits is greater than £30,000, the employer must make a report to HMRC. There is no set format for the report but it must specify:
- the estimated total amount of the payments and the cash equivalents of other benefits awarded, including payments and other benefits available in future years
- details of the payments made and the cash equivalent of non-cash benefits provided in the year of settlement (other than any already included in a P11D)
- the total number of years in which payments and benefits are to be provided
- details of any circumstances where the payments or other can be reduced. For example, a beneficial loan may continue only until an ex-employee finds new employment
The report must be made by 6 July after the end of the tax year.
Are any termination payments exempt from tax and NIC?
Yes, there are certain complete exemptions which are payments:
- made on death of the employee
- made on injury / disability of employee. Please note that ‘injury’ in this context does not refer to injury to feelings, but an injury causing an impairment affecting ability to do the job
- into a registered pension scheme
This is also a potential exemption or partial exemption where there has been foreign service ie some of the employment has been spent abroad. There is more on this in the commentary.
Are some elements of a termination payment subject to special rules for tax?
Yes, there are specific rules for restrictive covenants and legal fees.
How are restrictive covenants taxed?
Restrictive covenants are undertakings given by employees during employment or on termination that restrict their conduct or activities. Any amount specifically paid for these covenants is subject to tax and NIC in full.
Where no amount is specified, HMRC may seek to impose a value. It is therefore usual to specify a value where there are undertakings such as commercial restrictions on an employee leaving employment.
How are legal fees taxed?
There is no charge to tax on certain legal costs paid by the employer on behalf of the employee.
To be paid tax-free, the payment must meet the whole or part of the legal costs of the employee in connection with the termination, and one of the following must apply:
- the termination of the employment results in a settlement agreement between the employer and the employee that provides for payment to be made by the employer directly to the employee’s lawyer, or
- the payment is made pursuant to a court or tribunal order
How is payroll operated on termination payments?
All such payments are processed through the real time information system and the date of leaving is reported via the employer’s full payment submission.
For payments which are subject to tax, the treatment will depend on whether they are made before or after the P45 has been issued:
- Payments made before the P45 has been issues are subject to the employee’s normal PAYE code
- Payments made after the P45 is issued are taxed using a 0T code (which means that no personal allowance is given). Essentially, this taxes the payment as if it was paid in the first week or month of the tax year but without any personal allowances.