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The taxing question of Termination Payments

01 April 2016

What do bursars need to know about the taxation of payments to employees on the termination of their employment?

Bursars will be familiar with Settlement Agreements and the COT3 agreed through ACAS to record financial compensation linked to the settlement of employment related claims.  In the majority of cases the financial arrangements are straightforward; however a flurry of activity in the Courts recently intended to clarify the taxation of some types of termination payments may challenge existing perceptions. 

At the same time HMRC has led a consultation on proposed changes to the system for deducting tax and NICs from termination payments with findings due out soon. Proposals for reform include removing the distinction between contractual and non-contractual payments (so all payments made in connection with the termination of employment would be subject to income tax and National Insurance Contributions (NICs)), aligning the income tax and NIC treatment of termination payments and introducing a new exemption from tax and NICs.

So what are termination payments?

Termination payments are severance payments to employees on termination of their employment for any reason.

  • To reduce the tax liability and increase the certainty that no future liability will arise.
    • HMRC can recover unpaid tax, NICs, penalties and interest from the employer if termination payments are not taxed correctly. It is not always easy to recoup sums recovered by HMRC from an ex-employee even when there is an indemnity in place in favour of the employer.
    • An employer should consider the cost of and NICs.  In addition to employee's NICs , the employer must pay employer's NICs on payments that constitute earnings from employment.  This can add significantly to the cost of settlement.

Employers should clearly set out the grounds for payment in the Settlement Agreement or COT3. If an element of the payment represents damages for injury to feelings arising from an alleged detriment or act of discrimination suffered before, and separate to, a dismissal this should be spelled out to demonstrate to HMRC under which category the payment falls. The grounds for the payment should be supported by relevant documentation such as correspondence, a grievance, or a claim.

Taxation of payments on termination of employment is a complicated area of the law and we recommend employers take legal and accountancy advice when entering into an agreement with employees.

Termination payment - what is taxable and NIC - able?

  • contractural payments connected with past or future service such as salary, holiday pay, bonus and contractural payments in lieu of notice
  • payment in return for entering into new restrictive covenants
  • cash cancellation or compensation for loss of entitlement to share options ans hare awards
  • write-off loans to employees

Taxable but no NICs

  • non-contractural payments in excess of £30,000 made as a result of the termination including injury to feelings awards
  • lump sum paid to an employee who retires or is nearing retirement on termination of employment.


Which payments made on termination are not taxable and NIC-able?

  • injury to feelings payments or compensation for financial loss made to employees in relation to acts of discrimination and/or detriment  arising during the employment and not related to the termination of employment
  • legal fees in connection with a settlement agreement
  • outplacement counselling (subject to conditions)
  • contribution to registered pension scheme
  • death, injury or disability payments


If you would like to discuss any aspect of this article further, please contact Sue King on 0113 244 6100.

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The information in this article is necessarily of a general nature. Specific advice should be sought for specific situations. If you have any queries or need any legal advice please feel free to contact Wrigleys Solicitors.



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Sue King


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