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Termination payments: The treatment of tax and national insurance contributions

04 August 2015

The government is consulting on simplifying the way tax and national insurance contributions (NICs) are dealt with on termination payments.

The basics

There is a common mistaken belief that the first £30,000 of any payment contained in a termination package is tax free. This is not correct.

When an employee receives a financial package upon termination of employment, the payments can be made up from several components; these include:

  • Payment in Lieu of Notice (PILON)
  • Annual leave
  • Redundancy pay
  • Damages
  • Compensation for loss of employment

The components upon which an employee is contractually entitled to are subject to tax and NICs. Contractual payments include salary, bonus, notice pay and annual leave.

The components upon which an employee is not contractually entitled to can be free of tax and NICs provided that the amount does not exceed the current £30,000 exemption. Non-contractual payments include redundancy, damages and compensation for loss of employment.

If the contract of employment does not contain a PILON clause, a payment made under this category could be considered a compensation payment and therefore not subject to tax and NICs.

There are further exemptions from tax and NICs, reliefs and reductions which are not subject to tax, even if the amount exceed the exemption. These include the death, disability or injury of an employee, a tax exempt pensions scheme, a registered pension scheme, liabilities and indemnity insurance.


The Government is proposing to remove the distinction between contractual and non-contractual payments. This means that a PILON clause could attract a tax free status. Other key proposals include:

  • The removal of the current £30,000 exemption and introduction of a tax free amount which would increase in proportion to an employee’s length of service.
  • To make injury to feelings awards, usually tax free, subject to tax.
  • The introduction of a two year qualifying period before an employee is entitled to benefit from a tax free payment. It is intended that an employee would qualify for this once they have completed two years’ service. It means that an employee who receives a termination payment after completing two years of service would not have to pay tax and NICs (on a proportion, if not all, of the sum).

Whilst it has not been confirmed, the government has made reference to a £6,000 tax-free sum which would be applicable once an employee has over two years’ service, which would then increase by £1,000 for each additional year of employment.

Further guidance has been sought on the above proposals and a formal decision has not been made. See following link for full consultation:

Simplification of the Tax and National Insurance Treatment of Termination Payments