UK: Taxation of Termination Payments

Last Updated: 27 April 2010
Article by Conor Brindley

Although economic indicators point to the UK emerging marginally from recession, many employers are still finding they are under pressure to reduce their headcount. As such, it is useful to revisit the tax treatment of termination payments.

There is a widely held view that the first £30,000 of any termination payment is tax free. As this article will show, such a view is not necessarily correct. It is worth pointing out at this stage, that if an employer makes a termination payment and mistakenly believes that the first £30,000 is tax free, it is the employer who will be liable for any tax and/or national insurance contributions ("NIC") it should have paid or deducted in respect of the termination payment, plus interest and penalties. Whilst this risk can be mitigated to a certain extent by limited rights of recovery against a former employee and by including a tax indemnity from the employee in a compromise agreement, there may be practical difficulties and considerable expense for the employer in enforcing the indemnity.

General Principles

Termination payments are taxed under the Income Tax (Earnings and Pensions) Act 2003 ("ITEPA"). ITEPA contains a number of provisions which are potentially applicable to termination payments. It is, therefore, necessary to identify which provision is actually applicable to the termination payment in question. However, before the correct provision can be identified, the true nature of the payment needs to be determined, which will require assessing the basis on which the payment is made and considering all the background factual circumstances to the payment.

Often a termination payment will fall within more than one provision. Where this happens ITEPA states which provision is to take priority. In order to identify the correct provision, the following process should be used.

  1. Does the payment fall within the category of general earnings and as such taxable under Part 2 of ITEPA?

  2. Is the payment a taxable benefit and as such taxable under the benefits code in Chapters 2 to 11 of Part 3 of ITEPA?

  3. Is the payment for a restrictive covenant and as such taxable under Chapter 12 of Part 3 of ITEPA?

  4. Is the payment from an employer-financed retirement benefits scheme and as such taxable under Chapter 2 of Part 6 of ITEPA?

  5. If none of the above, is the payment in connection with the termination of a person's employment and as such taxable under sections 401 to 416 (Chapter 3 of Part 6 of ITEPA) and therefore within the £30,000 exemption?

The effect of the priority provisions is that where a payment is, for example, categorised as both a termination payment and general earnings, it will be taxed as general earnings rather than a termination payment.

As mentioned, it is necessary to ascertain the true nature of the payment to establish its tax and NIC treatment because the income tax and NIC treatment of termination payments varies depending on the type of payment involved. This is particularly important as HM Revenue & Customs ("HMRC") often challenge the nature of the payments especially where the £30,000 tax free exemption is being relied upon.

Termination payments typically take the form of one or more of the following: a payment in lieu of notice, compensation or damages for failure to serve notice, a statutory or contractual redundancy payment, compensation for a statutory employment claim (e.g. unfair dismissal, unlawful dismissal), an ex-gratia payment, retirement benefit or a benefit in kind (e.g. transfer of ownership of a company car, forgivable loans).

Clearly, where a termination payment consists of a number of different elements, it is necessary first of all to identify each of the elements and then to determine the true nature of each element.

Whilst the principles involved in determining the tax treatment of a termination payment are fairly straightforward, difficult questions are often raised in their application.

Is the Termination Payment Taxable under Part 2 of ITEPA?

The basis of taxation under Chapter 2 of Part 2 of ITEPA is set out in section 6(1), which provides that the charge to income tax on "employment income" is a charge on "general earnings" and "specific employment income".

The definitions of "employment income", "general earnings" and "specific employment income" are set out in section 7. The key to these definitions is whether or not a payment constitutes "earnings", which is defined in section 62 as:

  1. any salary, wages or fee;
  2. any gratuity or other profit or incidental benefit of any kind obtained by the employee if it is money or monies' worth; or
  3. anything else that constitutes an emolument of employment.

It is necessary to turn to case law relating to Schedule E of the Income and Corporation Taxes Act 1988 (the predecessor to sections 6 and 62 of ITEPA), to determine what constitutes an "emolument of employment" and whether the emolument arises from employment. It is beyond the scope of this article to consider this point in detail. It should be noted though that not all payments made by an employer to an employee will constitute earnings. However, any payment made to an employee in return for "acting as or being an employee" or "being or becoming an employee" will constitute earnings. Accordingly, whether or not a payment to an employee derives from his or her employment (and as such constitutes earnings) depends on the reason why the payment is made. In general, most contractual payments (e.g. payments made pursuant to an employee's employment contract) are liable to tax as section 62 earnings. In the Court of Appeal case of Dale v de Soissons1 it was held that a contractual payment stated to be compensation for loss of office (which was more akin to damages) was liable to tax as profit arising from his employment.

The most common payment made in connection with the termination of employment which does not constitute "earnings" is damages for wrongful dismissal.

Payments in Lieu of Notice

In practice the main difficulty that arises in respect of termination payments which are "payments in lieu of notice" (often referred to as Pilons) is whether such payments constitute "earnings" or damages. If the payment constitutes earnings, it is fully taxable. Whereas, if the payment constitutes damages, it should fall within the £30,000 exemption.

The phrase "payment in lieu of notice" is commonly used to describe at least four different types of payments:

  1. An employer gives proper notice of termination to his employee, tells the employee that he need not work until the termination date and gives him wages attributable to that notice period in a lump sum. In this case (commonly called "garden leave"), there is no breach of contract by the employer. The employment continues until the expiry of the notice and, as such, the lump sum payment is simply an advance payment of wages.
  2. The contract of employment provides expressly that the employment may be terminated either by notice or, on payment of a sum in lieu, summarily. In such a case, if the employer summarily dismisses the employee, he is not in breach of contract provided that he makes the payment in lieu. The payment in lieu is not a payment of wages in the ordinary sense, since it not a payment for work to be done under the contract of employment.
  3. At the end of employment, the employer and employee agree that the employment may be terminated immediately on payment of a sum in lieu of notice (this will invariably be the case where the employment contract does not give the employer the right to terminate summarily on payment of a sum in lieu of notice). Again, the employer is not in breach of contract by dismissing summarily and the payment in lieu is not strictly wages since it is not remuneration for work done during the continuance of employment.
  4. Without the agreement of the employee, the employer summarily dismisses the employee and makes a payment in lieu of proper notice. The employer is in breach of contract by dismissing the employee without proper notice. However, the summary dismissal is effective to put an end to the employment relationship. Since the employment relationship has ended, no further services are to be rendered by the employee under the contract. It follows that the payment in lieu of notice is not a payment of wages in the ordinary sense, since it is not a payment for work done under a contract of employment.

The tax treatment of Pilons within categories (a) to (c) above was considered in the case of EMI Group Electronics Ltd v Caldicott2. Such payments are generally fully taxable as emoluments arising from employment. However, categories (b) to (d) require further consideration.

Contractual Pilons

Where a Pilon is made pursuant to a contractual provision, it is taxable under section 62. It should be noted that a contractual Pilon clause may be found not just in the contract of employment, but may also be in any side letter to the main employment contract, the staff handbook, any letter of appointment, the redundancy agreement or an employer-union agreement.

Where there is a contractual Pilon clause, but the employee waives the right to notice or there is a mutual agreement to terminate early, HMRC will usually seek to tax the portion of any severance payment equivalent to the earnings for the notice period. This appears to be on the basis that there is no breach of contract and therefore the payment cannot be regarded as damages. Consequently, HMRC considers that the payment must be made under a contractual Pilon clause.

It should be noted that where an employee claims to have been constructively dismissed, it is arguable that any termination payment received by the employee is either damages for breach of contract or is a payment under the Pilon clause. If an employee actually resigns and the employer is in fundamental breach of contract, HMRC should not be able to argue successfully that payment is made under a contractual Pilon clause, as the employer, being in fundamental breach of contract, is no longer able to rely on any term of the contract. However, in such situations the employee often threatens to leave, but does not actually go, the employer then denies the breach and the parties reach a mutual agreement. In these circumstances, HMRC's view is generally that the employee has waived the breach and the payment was made under a contractual Pilon clause.

Implied Contractual Pilons and "Auto-Pilons"

Many employers have a custom of making Pilon payments even where there is no Pilon clause in the employment contract. Where this is the case and the employment contract in question does not contain a Pilon clause, HMRC is likely to view any Pilon as taxable under section 62 either on the basis that an implied contractual right to a Pilon has arisen or on the basis of the Pilon is an "auto-Pilon".

Following the Privy Council case of Reda v Flag3, HMRC appear to accept that it is rare for an implied term to become incorporated into a contract of employment by reason of custom and practice if it conflicts with an express obligation (e.g. an obligation to serve notice) in the contract.

However, in spite of HMRC's views that Pilon clauses can rarely be implied, HMRC put forward a similar argument in Tax Bulletin 63 (February 2003) which it refers to as the "auto-Pilon" argument. This argument has subsequently been refined and is currently dealt with in paragraph 2777 of HMRC's Employment Income Manual. HMRC's argument is that where the making of a Pilon is an "automatic response to termination", such a payment may constitute section 62 earnings. Whether or not HMRC's auto-Pilon argument would succeed in the courts remains to be seen. However, employers are advised to avoid establishing an automatic response of making Pilons. Employers, therefore, must be able to demonstrate that each case is looked at individually, a decision is made on a case by case basis about whether to require the employee to work their notice period, to go on garden leave or to receive a payment in lieu of notice. Further if the employee is not required to work their notice period, the employer should consider the amount of the payment in lieu of the notice period and, in particular, it should consider whether to pay in full or make a deduction for any mitigation and accelerated receipt.

Discretionary Pilons

In the Court of Appeal case of the EMI Group Electronics Ltd v Caldicott, it was held that where a contract gives the employer a discretionary right to make a Pilon, any such payment would be taxable as an emolument from employment.

However, if the employer does not exercise its discretion to make a Pilon under the terms of the contract, but instead makes a payment of damages, the tax treatment should be different. In the Court of Appeal case of Cerberus Software Ltd v Rowley4 it was held that a payment made after an employee's summary dismissal and pursuant to a decision by the Employment Tribunal, was a payment of damages, despite a right in the contract for the employer to make a Pilon. A discretionary Pilon clause does not provide the employee with a right to demand payment, it merely gives the employer the choice as to whether to make a payment in lieu of notice or not.

Whilst HMRC now accepts that in principle, damages paid following a failure to exercise a discretionary Pilon clause are taxable under section 401 of ITEPA (and therefore qualify for the £30,000 exemption), it should be noted that HMRC and the courts will critically analyse such a payment to determine whether it is a payment of damages or a payment pursuant to a Pilon clause.

Nature of the Payment

Where an employment contract contains either a discretionary Pilon clause or no Pilon clause and the employer makes a termination payment, which for tax purposes is intended to be treated as damages or compensation for breach of contract, the guidelines below should be followed to reduce the risk of a successful HMRC challenge:

  1. the size of the payment should reflect the fact that there will be accelerated receipt;
  2. the size of the payment should reflect any mitigation of loss by the former employer;

  3. the size of the payment should reflect the different tax treatment of damages; and

  4. the size of the payment should reflect all the salary and benefits (as opposed to just the salary) that the former employee would otherwise have been entitled to.

Clear documentary evidence showing the reasons for making the payment and how the payment was calculated should be produced and retained.

It should be noted that the courts tend to be reluctant to find there has been a breach of contract resulting in the termination payment being treated as damages or compensation. This has recently been shown in the case of Cornell v Revenue & Customs5.

Other Payments

A detailed consideration of the tax treatment of the other types of termination payments is beyond the scope of this article. However, it should be noted that sections 401 to 416 which deal with the taxation of payments and other benefits received in connection with the termination of employment are widely drafted and are designed to catch all payments and benefits that are not earnings and so are not taxed under section 62. Accordingly, rarely will ex-gratia payments (in excess of £30,000) escape liability to tax altogether. The first £30,000 of payments that fall within section 401 are exempt from tax and any excess will be subject to income tax in the normal way. If the payment relates to foreign service, there may be a partial or complete exemption from tax.

As previously mentioned, it should not be forgotten that sections 401 to 416 act as charging provisions on termination payments where no other charging provisions apply.

Below is a brief summary of the other common types of termination payment.

Statutory Redundancy Payments

Statutory redundancy payments are exempt from tax by section 309 of ITEPA.

Non-statutory redundancy payments whether contractual or non-contractual, should fall within sections 401 to 416 of ITEPA and therefore qualify for the £30,000 exemption, provided they are paid genuinely on account of redundancy and are not a form of terminal bonus.

Restrictive Covenants

Any payment made for restrictive covenants is fully taxable under sections 225 and 226 of ITEPA. If a former employee is required to give restrictive covenants as part of a compromise settlement, the consideration for the restrictive covenants should be set out in the compromise agreement. This is to reduce the risk of HMRC successfully arguing that a larger amount is attributable to the restrictive covenants. The consideration should be reasonable compared with the value of the rest of the package.

National Insurance Contributions

Payments that constitute section 62 earnings are subject to NIC (both employer and employee). However, payments that are liable to tax under section 401 of ITEPA are generally not liable to NIC even if they exceed £30,000.


1. 32 TC 118

2. [1999] STC 803,811

3. [2002] IRLR 747

4. [2001] IRLR 160

5. [2009] UKFTT 140 (TC)

This publication is intended merely to highlight issues and not to be comprehensive nor to provide legal advice. Conor Brindley heads up the tax group at Rosenblatt Solicitors and can be contacted at

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.