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Proposals for Reforming the Tax Treatment of Termination Payments

  • United Kingdom
  • Tax planning and consultancy



On 24 July 2015 the government launched a consultation into the income tax and national insurance treatment of termination payments, with the aim of exploring how this treatment can be made simpler and fairer.

Current Tax Treatment

Termination packages are often made up of several different elements, for example, damages, statutory redundancy, payments in lieu of notice (PILON) and compensation for loss of office.

Under the current tax regime, elements of the termination package that are from the employment or that an employee is contractually entitled to, will generally be subject to income tax and national insurance in the same way as other payments of salary. In contrast, any elements of a termination package that are compensatory may only be liable to income tax on amounts exceeding £30,000 and may not be subject to national insurance at all.

Proposed Reforms

It has been recognised that the present tax system can give rise to complexity and confusion as employers are required to consider each element of an employee’s termination package separately to determine the appropriate tax and national insurance treatment.

1) Removing the Distinction between the Tax and National Insurance Treatment of Contractual and Non-Contractual Payments

The government intends that under the revised tax system for termination payments, all payments made in connection with termination of an employment will be earnings and subject to income tax and national insurance in full. However, support in the form of relief from income tax and national insurance should still be available to employees who lose their job by virtue of the introduction of a new basic tax exemption.

The government has also proposed that any change to the tax treatment of termination payments should align the income tax and national insurance treatment of such payments.

These proposals, if implemented, will mean that employers will no longer need to consider which elements of a termination package are taxable and which are not, thereby removing the complexity and confusion under the current regime and leading to a simpler tax system.

2) New Tax Exemption

As part of the new tax treatment of termination payments, the government is proposing to introduce a new basic tax exemption which would increase proportionately with the number of years’ service the employee has completed.

It considers that structuring the exemption in this manner would create a fairer exemption which would proportionately reward long serving, lower paid employees and that linking the availability of the relief to the length of service of the employee would create a simpler system. For the exemption to be available the employee would have to have completed two years’ of service, following which the exemption would increase at a set rate with each year of service completed up to a maximum amount.

Although specific amounts or thresholds for the new basic tax exemption are not set out in the consultation document, a worked hypothetical example suggests a £6,000 tax-free sum after two years’ employment, increasing by £1,000 for each additional year of employment. If this basic level of tax-free sum is implemented as part of the new tax system for termination payments, this will result in a significantly reduced tax-free sum being available for almost all employees when their employment terminates.

The government is also considering whether the new tax exemption should only apply in circumstances where the termination payment has been made in connection with redundancy as defined in section 139 of the Employment Rights Act 1996, as it suggests that this would mean that the exemption would be targeted at those who are most in need.

3) Other Exemptions

The government’s present proposal is to remove some of the additional exemptions which are currently available. However, it has confirmed that it intends to retain the exemptions for injury or disability and HM Forces payments.

The government has also indicated that if the new tax exemption is limited to payments made in connection with redundancy, then it will consider introducing two further tax exemptions for payments made in connection with wrongful or unfair dismissal or compensatory payments made in cases of discrimination.


The period of consultation will end on 16 October 2015 and it is expected that the government will make an announcement in the Autumn Statement 2015.

It will be interesting to see which (if any) of the above proposals for the reform of the current tax treatment of termination payments are actually implemented, and whether any reforms result in a simplification of the current system.

Although simplification of the rules is to be welcomed, based on the current proposals this would come at a cost for employees who will be financially worse off if the basic level of any tax free sum is reduced below the current £30,000 threshold.