There is a generous tax exemption available which allows up to £30,000 to be paid to an employee tax free as part of a severance payment on termination of their employment. However, please note that payments in lieu of notice (PILON) are fully taxable and subject to both employee and employer National Insurance Contributions (NICs) regardless of whether there is a PILON clause in the contract of employment.
Termination payments can, essentially, be split into two parts:
If the PENP is equal to or greater than the entire termination payment, then the £30,000 exemption does not apply, and the entire amount is fully taxable.
If the PENP is less than the entire termination payment, the portion of the payment that exceeds the PENP will be tax free up to £30,000. The remainder of the payment is treated as taxable earnings.
The calculation of PENP differs depending on a number of factors.
The basic formula is: ((BP x D) ÷ P) – T, where:
Note that D is calculated by reference to the notice that the employer must give (by contract or law). This may be different from the period of notice that the employee must give.
This is a complex area and there are detailed requirements. It should also be remembered that, in addition to the tax considerations outlined above, there are legal requirements connected with termination of employment. An employer should therefore ensure they take advice on both the tax and the employment law aspects of this complex issue.
Disclaimer: This note does not contain a full statement of the law and it does not constitute legal advice. Please seek legal advice if you have any questions about the information set out above.
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