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Taxation: Written in Stone

‘Written in Stone’ 
This article was first published in Taxation. For further information visit
David Reade QC suggests that proposals for simplifying the tax and National Insurance treatment of termination payments may hold complications for employers and employees who firmly believe in the right to exemption.

Employment lawyers will say that the one piece of tax law is engraved on every departing employee’s heart is a belief in their entitlement to a termination payment of up to £30,000 tax free. The position is, of course, not that straightforward and the possible simplification of the tax and National Insurance treatment of these payments has been the subject of consultation with HMRC. The consultation document can be found here and in particular, views were sought on:

  • removing the distinction between contractual and non-contractual termination payments and whether this will make it easier for employers and employees to understand;
  • the design of the new exemption from income tax and National Insurance contributions;
  • whether the income tax and National Insurance treatment of termination payments should be aligned; and
  • which of the existing exemptions that remove the liability to income tax should be retained and whether any new exemptions should be introduced.

The Employment Lawyers Association (ELA) responded to the consultation, identifying some serious concerns with the proposals.

Key Points

  • Most employees are certain of their entitlement to a £30,000 exemption for termination payments.
  • Proposal to abolish the £30,000 tax relief and introduce a relief based on years of service.
  • The value of the exemption has been eroded by inflation and should now be about £70,000.
  • Proposals that the relief should not apply to resignations and those working under fixed-term contracts.
  • The exemptions for injury, disability, legal costs and others should be retained.

Payments in lieu of notice

The taxation provisions for termination payments, and with them the present £30,000 exemption from tax and freedom from National Insurance contributions (NICs) liability, do not extend to a payment in lieu of notice (PILON) if this is made pursuant to such a clause under their contract. In such cases, the payment is taxed as earnings and attracts Class 1 primary and secondary contributions.

PILON clauses are important for employers, enabling them to terminate a contract lawfully and immediately without breaking it and rendering post-termination restraints unenforceable. The distinction between contractual and non-contractual PILON payments makes little sense and has led to arguments with HMRC around “auto-PILON”. Removing the distinction between contractual and non-contractual termination payments would then simplify the position.

But what should be the direction of travel of any simplification? Simply imposing Class 1 primary (employee) and secondary (employer) NICs on all termination payments would substantially increase costs to employers of terminating employment – and that could potentially decrease flexibility in the workforce.

The ELA’s view was that the proposed New Exemption Proposal should extend the NIC exemption to employers aligning the treatment by reducing rather than increasing the NIC burden. Putting to one side that proposal, if one takes the purpose of the tax relief on termination payments to be, first, to assist employees at a time of hardship and, second, to make it easier and cheaper for employers and employees to reach a settlement, thereby avoiding their disputes reaching an employment tribunal, no merit is seen in applying NICs to such payments. Although it would increase HMRC revenues, it would go nowhere towards either of the stated fairness or simplification objectives of the consultation. The consultation paper does not contain any evidence of employers having particular difficulties with the current distinction.

New Exemption Proposal 

4.16. One approach the government is considering is to create a new exemption which increases proportionately with the number of years of service the employee has completed. This would create a new fairer exemption which will proportionately reward long-serving, lower- paid employees. Linking the availability of relief to the length of service of the employee would create a simple system that is easy to understand and easy for employers to administer.
4.17. The employee would qualify for the exemption once they have completed two years of service. This would mean that anyone who receives a termination payment after completing two years of service would not have to pay tax and National Insurance contributions on some, or possibly all, of their award (depending on the size of their award). The level of the tax and National Insurance contributions exemption would then increase at a set rate with each year of service completed up to a maximum amount.
4.18. To count for the exemption the years of service would need to be with the same employer or with an associated employer – such as employment within another company within the same group. The years of service would also include any change of employment where the employee’s change of employer was under a Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE) scheme.

The proposed new exemption

Although there is value in the alignment of the tax treatment of PILON payments, which formed part of the proposals, there is concern about the effect of the wider proposal to abolish the £30,000 tax allowance on compensation payments and to introduce a relief based on years of service. Under the proposals, the relief would apply only if an employee had two years’ service and would then increase progressively with years of service to a maximum.

The proposal would decrease the amount of tax relief available for employees at a time of particular financial hardship. Further, the increased cost to employers of imposing NICs, as a consequence of the proposed alignment, would make termination payments more expensive for employers. It is likely that this would affect the severance payments on offer, particularly if many redundancies are made at the same time. This would be to the obvious detriment of the staff affected. The employees most likely to be affected prejudicially by this are lower earners. For them, the £30,000 tax relief, and the fact that NICs are not paid on compensation, is proportionately the most significant. Likewise, an increased NICs burden on termination payments would increase the cost of terminating employment and settling cases for all employers, but it would be a more significant burden for small employers.

The proposals for the new exemption would appear to have the effect of reducing the threshold for the exemption on termination payments by using the length of service-based exemption. The practical effect would appear to be a far lower maximum than the current £30,000. Working from the proposals, on a length of service-based threshold, an employee would appear to need 26 years’ service to achieve the current £30,000 exemption. Experience suggests that fewer employees achieve this length of service in today’s labour market. In reality, the lower paid and more vulnerable are those least likely to. Thus, the proposed length of service requirements would achieve the diametrically opposite result to the government’s expressed aim of ensuring that the exemption is fair to those who are lower paid and more vulnerable.

Length of service requirement

It was also noted that government would have to consider whether introducing a length of service requirement for the exemption would be indirectly discriminatory. Such a requirement may have a disparate impact on those with protected characteristics. For example, the new proposal may disproportionately affect women for whom the needs of parenthood may have led to patterns of shorter service.

There are further practical problems in the application of the proposed new exemption. It is not always easy to calculate someone’s relevant length of service. In today’s workplace, individuals may work for employers in several capacities at different times of the relationship – for example, as employees, casual workers, self-employed, or on zero-hour contracts. Employers would have difficulty working out which periods of engagement under these different arrangements count towards the length of service requirement. That difficulty would be compounded by the length of service exemption requiring the employer to calculate the threshold for each separate employee. In a redundancy exercise involving more than a few employees, this would be administratively burdensome. In contrast, under the current regime, an employer knows that each employee whose position is terminated is entitled to the same relief up to the £30,000 maximum and can use standardised documents.

Administration difficulties

The proposals also suggest that the relief might be limited to those being made redundant. That will not be easier for employers to administer. The current regime does not limit the termination circumstances in which the exemption applies. The ELA’s view was that employers do not find this element of the regime complicated. The fact that the exemption applies regardless of the termination context makes it easier for them to understand and administer. Redundancy has, however, a technical meaning with a body of case law on its application. Linking the relief to the definition of redundancy will leave employers having to form an opinion about whether a particular termination is within the definition of redundancy, to decide whether tax relief can be applied. There are often situations in which that issue is not clear-cut. For example, business reorganisations mean redundancies. However, this is not the case if, for example, the overall volume of work does not diminish and the employer is introducing new ways of performing the same tasks. It seems wrong for an employee made redundant within the statutory definition to benefit from the proposed exemption, but not someone whose dismissal was the result of a reorganisation that did not, technically, amount to a redundancy. This could create problems for HMRC as well as for employers because the department will have to determine whether, on any given set of facts, the exemption applies. Employers and employees may be pressured to shoehorn terminations into a redundancy or, worse, simply mislabel the termination as a redundancy when that is not the case.

Finally, on the threshold itself, the reality is that the value of the existing one has been steadily eroded. Since its introduction 55 years ago. It was increased to its current £30,000 level 27 years ago in 1988/89. If the exemption threshold had been inflation-adjusted since, it would now stand at more than £70,000. Although this is wider policy consideration, the government should consider raising the maximum threshold.
Anti-avoidance provisions

The proposals for anti-avoidance provisions under the new exemption proposal raise additional problems. The consultation document states that the government does not intend to provide tax relief to those who choose to resign. A distinction must be drawn between employees who resign without cause (and where the concept of compensation should not therefore validly arise) and those who resign with cause; for example, those who contend they have been constructively dismissed. It would be inequitable to debar employees who have been constructively dismissed from the tax and NIC reliefs available to employees who have been expressly dismissed.

The consultation document also states that the government does not intend to provide tax relief to those working under fixed-term contracts. The proposal is unclear, but it must be assumed that this restriction will be limited to situations in which the fixed-term contract is terminated in the circumstances intended or envisaged at the outset and not by earlier breach. This aside, there is no reason to disentitle fixed-term workers from tax relief where the reason for that differentiation was their status alone, particularly given that expiry of a fixed-term contract constitutes a “dismissal” in law. As to the problem to which this part of the proposal was said to be directed, we have not encountered employers and employees using termination payments in the context of fixed-term contracts to disguise earnings.

It is suggested that the government also intends to recover tax and NICs on termination payments if the individual is re-engaged in the following 12 months to do a similar job. This proposal brings with it particular complexities and would require limitations. For example, this should expressly exclude circumstances in which the employee is re-engaged by reason of a later TUPE transfer or other acquisition that affects his employment with a subsequent employer or which results in their re-engagement (or subsequent consultancy arrangements) through “accidental” means. The government will also need to consider carefully, and provide practical guidance, on what is meant by “similar” in these circumstances. Is it limiting its views to employment relationships or is it intended to include subsequent short-term consultancies as often occurs after work in central government or the NHS? The provision may have the intended consequence of impairing flexibility for employers. The similarity should be adjudged by reference to remuneration rather than role and the imposition of a blanket 12-month repayment period could result in employees having to repay a potentially significant sum of tax and/or NICs in circumstances where they have been out of work for a lengthy period and consequently may not have the means to do so. If this proposal is to be implemented, a remission or phased repayment scheme should be considered.

Other exemptions 

The existing exemption for payments for injury or disability should be maintained and there should be no cap on it. The foreign service exemption should be removed. The proposals note, however, that if the exemption is removed territorial limits for termination payments will be adopted in line with all other payments of employment income. Further explanation and illustration of this point is needed so that the extent of any proposed changes are made clear.

The exemption for the payment of legal costs should be retained. The consultation paper raises a concern that this exemption is used to pay for legal advice with the sole purpose of reducing tax and NICs liability for employees and employers. This appears to arise from cases where large costs have been incurred. Legal costs can vary not so much because of advance tax planning, but because of the difficulty employees face in obtaining appropriate termination packages from employers. It is not uncommon for employees to struggle to secure an appropriate termination payment with the result that they may incur significant legal costs. Removing the separate legal costs exemption could have a harsh impact on employees through no fault of their own.

The current outplacement costs exemption should be retained. Without this, employees would suffer an income tax charge on a service, rather than a payment, they receive. Without outplacement help, many employees will be out of work for longer periods, possibly putting more pressure on the public purse. Equally, the exemption for contributions to registered pension schemes should be retained. Both are valuable exemptions for employees who lose their jobs and the latter accords with the government’s aim to encourage individuals to provide for their own retirement.

Unfair or wrongful dismissals

There were divided views over a possible cap above which income tax and possibly NIC should be payable in cases of unfair or wrongful dismissal. There were equally divided views over whether there should be a difference in the application of a cap in cases in which the payments have been settled by a tribunal or by an arrangement between employee and employer. There was unanimity on whether there should be financial cap, above which income tax (and possibly NICs) should be payable in cases of discrimination. There were serious concerns about the potential ramifications of that proposal. The concern was that such a position might encourage employees to allege they had been discriminated against to achieve a more favourable tax and NICs treatment. That would be exacerbated if the current £30,000 were removed or materially reduced for non-discrimination based termination payments. The prospect of a tax-free sum becoming available through reference to discrimination would then significantly increase the attraction of a discrimination allegation or claim.

There were differences of opinion as to the correct approach. Some members thought the approach should mirror (exactly or materially) the treatment of payments that are not referable to discrimination. Others would not want to undermine the important protections and prohibitions against all forms of discrimination, harassment and victimisation because of protected characteristics.


Although there is merit in parts of the proposals, there is serious concern about the new form of exemption. For many employees, this will significantly reduce the tax relief they enjoy on the termination of employment and it could have an adverse impact on lower-paid employees. Employers will find the proposals more difficult to operate and they would incur higher costs in redundancies. Of course, ultimately, this may be about increasing the contribution to the public purse rather than simplification. The failure to increase the present exemption over the past 27 years may suggest that the proposals are simply an acceleration of something that has been happening for a number of years: a “withering on the vine”.

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