Q What compensation can be paid tax free on termination?

A On termination of employment, up to £30,000 can be paid to an employee, tax free, if there is no reason why the payment should be taxed. Termination payments include statutory redundancy payments and compensation for unfair dismissal, but an incentive bonus paid on termination will not be tax free.

Q What tax should be deducted from any compensation amount in excess of the tax-free limit?

A The termination payment should be made after the employee has received their P45, in which case only basic rate tax need be deducted on any excess over £30,000.

Q Do the terms of the employment contract have any bearing on the tax status?

A Yes. If the payment is in accordance with the terms of a contract, then the payment will be taxed in full. The most common contractual payments are accrued holiday pay or payment in lieu of notice. If the employee is asked to assist with a handover of work after leaving, or is required to enter into any other form of contractual restriction over their future activities, the termination payment will be taxable in full.

Q We have agreed that an employee will leave at the end of their three-month notice period, and we will then make a tax-free payment. Is this OK?

A No. Her Majesty’s Revenue & Customs (HMRC) may argue that the payment is being made under the terms of a new contract entered into with the employee to record the variation, and therefore the payment will be taxable in full.

Q How should I record the payment?

A You should ensure that there is a written statement recording what has been paid and the reasons for the payment. Normally, the employee will be asked to sign a statutory compromise agreement. This should make clear what is to be paid, the reason for the payment, and what tax the employer is going to deduct.

Q What tax is due on a payment to an employee on the termination of the employment by reason of his retirement?

A Normally, a payment linked to an employee’s retirement would not be free of tax. However, in view of the new age discrimination legislation, it may be easier for an employer to show that such a payment is made only in respect of the termination of the employment, and not as a reward for past service or a payment to a non-approved pension arrangement.

Q How can we protect ourselves from claims for unpaid tax?

A Most employers paying compensation without deducting tax normally require the employee to give an indemnity in respect of any tax due by reason of the HMRC challenging the payment and the deductions made. Indemnities are unattractive to enforce against former employees and, where there is any doubt about what tax should be deducted, the employer should seek guidance from HMRC and deduct the appropriate tax on making the payment.

Q Can we pay enhanced redundancy payments tax free?

A If the payment is non-contractual it can be paid tax free up to the tax-free limit – even if it is a term of the contract – as long as approval for the arrangement has been obtained from HMRC, but the payment must fall within the precise terms of the concession that is given for such arrangements that mirror the statutory scheme.

Q In what other circumstances can a payment be paid tax free?

A Payments of compensation for personal injury/disability, where the employee is unable to continue to work as before, can be paid free of tax, but the employer will have to show that the employee qualifies for this tax treatment. A payment for compensation for a lesser form of personal injury on termination of employment can be paid tax free up to the tax-free limit.

Payment of legal costs in respect of the termination and outplacement costs can be tax free, but this is a concession from HMRC, so it is important to follow the concession terms precisely to qualify. For example, outplacement costs are taxable in full if the employee has less than two years’ service and outplacement is not normally provided by the employer.

In certain cases, it may be possible to make a tax-free payment to an employee’s pension scheme, but this will be subject to other tax rules, so employers should take advice before the payment is made.

By Alan Julyan, senior partner, Speechly Bircham

HM Revenue & Customs’ manual on termination payments

HM Revenue & Customs’ own Q&A page on termination payments


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