The rules on the tax and National Insurance treatment of termination payments is changing from 6 April 2018.

Payments made on the termination of an employment are treated differently depending on whether the payment is a payment of earnings, such as normal wages and salary, or a compensation payment, such as damages for loss of office.  Payments taxed as compensation payments benefit from a £30,000 tax-free exemption and are only taxable to the extent that they exceed £30,000.  The £30,000 exemption does not apply to payments taxed as earnings.

It is not always easy to determine whether a payment is one of earnings or a compensation payment benefitting from the £30,000 exemption.  In particular, payments referred to as ‘payments in lieu of notice’ cause difficulty in practice, not least because the term is used to describe payments that differ in nature.  Under the current rules, payments in lieu which the employee is contractually entitled to receive,  or which the employee has an expectation of receiving (for example, where there is a long standing company practice of making payments in lieu of notice), are taxed as earnings and do not benefit from the £30,000 exemption.

The treatment of payments in lieu of notice is to change from 6 April 2018 onwards.  From that date, the payment is compared to the pay that the employee would have received had the employment continued throughout the notice period.  Where the termination payment is not more than the pay that the employee would have received in the notice period had the employment been terminated, it is taxable in full.  Any excess over what would have been payable had the employment continued is treated as a compensation payment and will benefit from the £30,000 exemption.  Essentially, any earnings payable until the end of the notice period are taxed in full as earnings from the employment.

The way in which compensation payments are treated for National Insurance purposes is also changing from 6 April 2018.  Prior to that date, no National Insurance is payable on termination payments treated as compensation payments rather than as earnings.  However, from 6 April 2018, employer National Insurance contributions will be payable on compensation payments made in the termination of employment to the extent that they exceed the £30,000 tax-free threshold – although the payments will remain free of employee’s National Insurance.  The employee will pay tax on compensation payments in excess of £30,000 (as now) and the employer will pay employer’s National Insurance.