Question Of The Month: Can We Pay A Tax Free Lump Sum On Termination Of Employment?

Author:Ms Alacoque Marvin
Profession:Wrigleys Solicitors

The answer to this is very likely to be...NO

Settlement agreements can provide a useful way of bringing what might be a difficult employment relationship to an end. They offer peace of mind for the employer, considerably lowering the risk of any employment tribunal or court claims. For the employee, they can offer the incentive of a lump sum payment. In the past, "compensation" or "ex gratia" payments above and beyond any contractual notice pay might have been offered tax free. That is, as a payment in connection with termination coming within the £30,000 tax exemption threshold under sections 401-416 Income Tax (Earnings and Pensions) Act 2003.

New tax rules brought in on 6 April 2018 (but still frequently overlooked or misunderstood) mean that this is frequently not now possible.

The new tax rules on termination payments (from 6 April 2018)

Notice pay or its equivalent is now always taxed as earnings; whether as contractual pay in lieu of notice (PILON) or as a non-contractual payment. It is irrelevant how the payment is labelled by the employer. Any rounding up of a payment based on notice pay (as might have been proposed under the old rules) will also have no impact on the application of the new rules.

If the contract includes a right to a PILON

In this case, notice pay under the contract will be subject to deductions (as was previously the case) and the new rules will not apply.

If there is no contractual PILON

The amount which would have been paid for any unworked notice must be calculated (based on actual pay during the last pay period). This is called Post-Employment Notice Pay (PENP). Any PENP within a severance payment will be subject to tax and National Insurance contributions (NICs). It is important to note that the notice period in question is the notice the employee would be entitled to from the employer immediately before termination.

For example

An employee would be entitled to one month's notice from the employer. She earns £2,000 gross per month. A settlement agreement is proposed including a severance payment of £10,000. No notice will be worked. There is no right to pay in lieu of notice in her contract. £2,000 of the payment (pay for the one month notional notice period) will be subject to tax and NICs. The remaining £8,000 will be exempt from tax as a termination payment coming under the £30,000 threshold.

Where some or all notice is worked

If the employee works the full notice period, there will be no...

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