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Taxation of Termination Payments - Are You Getting it Right?

on Friday, 01 March 2019.

It is nearly a year since the rules on the taxation of termination payments for employees changed back in April 2018. The changes continue to prompt queries from our charity clients, so what do you need to know?

The most significant change was that payments in lieu of notice must be treated as 'earnings' and therefore subject to deductions for income tax and National Insurance. Charities must ensure that they are aware of the statutory formula and how it applies in practice in order to ensure compliance with the new rules.

What Changed?

Before 6 April 2018, the tax treatment of a payment in lieu of notice depended on whether there was a contractual right to make a payment in lieu of notice (whether explicit or implied). In the absence of a contractual right, the payment in lieu of notice could be paid as free from deductions as compensation.

The government overhauled this so that, now, regardless of whether there is a contractual right to make the payment, all payments in lieu of notice must be subject to deductions. The basic pay an employee would have earned had he or she worked his or her notice in full, called 'post-employment notice pay' (PENP), must be treated as earnings.

The Law

Whilst the principle appears straightforward, charities need to be aware that the relevant legislation sets out a prescribed statutory formula which must be used to calculate PENP. The difficulty is that the outcome of the statutory PENP formula will not necessarily be the same as the charity's calculation of payment in lieu of notice. In fact, the outcome of the formula can change depending on when the relevant trigger date (being the termination date or the date on which notice is given) occurs.

The risk in not considering the statutory formula is that it leads to non-compliance with the new rules, and therefore potential liability for further tax and penalties by HMRC.

It is necessary to consider the new rules and undertake the statutory PENP calculation whenever an employee leaves their employment:

  • without working their full contractual notice
  • receives a 'relevant termination award' (broadly speaking , something 'extra' which is not a contractual payment or a statutory redundancy payment)

This is the case regardless of whether the employee leaves under the terms of a settlement agreement or otherwise.

Best Practice

Charities will need to consider the PENP rules and formula when making any termination payment to an employee/ex-employee who has not worked their full contractual notice period.

We recommend that, where relevant, charities retain a copy of the PENP calculation on file so they can evidence to HMRC that any termination payment was appropriately taxed.

For those charities who engage external payroll providers, we recommend checking with the payroll provider that this issue is understood and termination payments are processed appropriately in line with the law.

Charities should also note that the change in law means there is no longer any benefit to omitting a contractual right to make a payment in lieu of notice from an employee's contract. On the contrary, we recommend that a contractual right to make a payment in lieu of notice is included in all contracts (and expressly limits the payment to basic pay).


For more information, please contact Charlotte Rose in our Employment Law team on 0117 314 5219.