Termination payments are often a key element of severance arrangements for senior executives. Whether the departure is amicable, part of a wider restructure, or the result of a dispute, it is crucial for both the executive and their employer to structure the termination package in a tax-efficient way. Missteps can lead to unnecessary tax liabilities or missed opportunities.
In this article, we examine the UK tax rules governing termination payments and set out strategies that senior executives can use to maximise the tax-efficiency of their exit arrangements.
Understanding Termination Payments
Termination payments (often referred to as severance payments or exit packages) are sums paid to an employee when their employment ends. These may include:
- Contractual entitlements: such as notice pay, bonuses, and outstanding holiday pay.
- Non-contractual or discretionary payments: such as ex gratia sums or settlement amounts negotiated as part of a settlement agreement.
- Statutory redundancy pay: where applicable.
- Post-termination benefits: such as continued private medical cover or outplacement services.
Each of these components may be taxed differently depending on the nature of the payment and how it is structured.
The £30,000 Tax Exemption
One of the most well-known features of the UK tax regime for termination payments is the £30,000 tax exemption. Under section 403 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA), the first £30,000 of certain qualifying termination payments can be paid free of income tax.
To qualify for this exemption, the payment must:
- Not be earnings (i.e. not contractual pay or benefits),
- Not fall within any specific taxable category (e.g. PILON or bonuses),
- Be made in connection with the termination of employment.
Any amount above £30,000 is subject to income tax in the usual way, and since April 2020, all sums exceeding £30,000 are also subject to employer’s National Insurance contributions (NICs). Notably, employee NICs are not payable, regardless of the size of the payment.
Payments That Do Not Qualify for the £30,000 Exemption
Some common termination-related payments are fully taxable, and cannot benefit from the £30,000 exemption. These include:
- Contractual payments in lieu of notice (PILON): These are treated as earnings and subject to income tax and both employee and employer NICs.
- Accrued holiday pay: This is considered earnings and fully taxable.
- Bonuses and commissions: If earned prior to termination, these are taxed as normal earnings.
- Restrictive covenant payments: For example, sums paid in return for agreeing to non-compete or non-solicitation clauses are taxable in full.
A proper understanding of how each component of the package is characterised is therefore vital.
Strategies for Maximising Tax-Efficiency
1. Distinguish Between Contractual and Non-Contractual Payments
A key starting point is identifying which elements of the severance package are contractual and which are non-contractual. Contractual sums are treated as taxable earnings, while qualifying non-contractual payments may benefit from the £30,000 exemption.
Employers and executives should review the employment contract and any relevant bonus or share scheme documentation to understand what is contractually owed, and they may wish to obtain independent legal advice from UK employment solicitors. Where discretion exists (e.g. with certain bonuses or goodwill payments), there may be scope to characterise a portion of the severance package as non-contractual.
Legal tip: Be cautious about labelling a payment as “ex gratia” – if it turns out to be contractually due in any way, HMRC will treat it as taxable earnings regardless of how it is described in the documentation.
2. Consider the Use of Settlement Agreements
Settlement agreements can be an effective vehicle for structuring tax-efficient termination packages. Where a genuine dispute exists – for example, around unfair dismissal or whistleblowing – settlement payments made as compensation for potential legal claims can be classified as non-contractual damages and may fall within the £30,000 exemption.
HMRC accepts that payments to settle employment disputes can benefit from the tax-free exemption provided they are not in respect of contractual entitlements or specific taxable benefits.
Practical note: The settlement agreement should clearly separate each element of the payment and record the basis for the payment – for example, by distinguishing statutory redundancy, PILON, and damages for loss of office.
3. Negotiate Timing and Phasing of Payments
In some cases, it may be possible to defer or phase elements of the termination payment into a new tax year to manage marginal tax rates. For example, an executive leaving late in the tax year might benefit from splitting taxable sums across two tax years, particularly if their post-termination income will be significantly lower.
This approach requires careful timing and a clear agreement with the employer about payment schedules.
Note of caution: Deferral for tax purposes must not conflict with anti-avoidance rules, such as the disguised remuneration rules or deferred remuneration rules applicable to regulated financial sector employees.
4. Explore Employer Pension Contributions
Employers may be willing to make a termination-linked pension contribution on behalf of the executive as part of the overall settlement. Provided it is structured correctly, this can be more tax-efficient than paying an equivalent cash amount.
Employer pension contributions are not treated as earnings for income tax or NICs purposes, and can therefore provide a legitimate way to maximise post-tax value.
Executives should consider their annual allowance and lifetime allowance (if applicable) to avoid unintended tax charges. They should also seek independent financial advice on pension contributions as part of a broader tax planning strategy.
5. Review Share Schemes and LTIPs
For senior executives, share schemes, long-term incentive plans (LTIPs), and carried interest arrangements can represent significant value. The tax treatment of these arrangements can be complex on termination.
Points to consider include:
- Whether leaver provisions cause forfeiture or accelerated vesting;
- Whether shares or options are taxed as income or capital;
- Whether any elections (e.g. section 431 ITEPA elections) were made.
Early legal and tax advice is essential. In some cases, restructuring a portion of the package to trigger capital gains tax treatment (at 20%) rather than income tax (up to 45%) may offer material savings.
