Termination payments: What employers need to know about tax rules and compliance

Summary

• £30,000 exemption applies to qualifying termination payments, not contractual earnings
• Genuine redundancy means the role is redundant, not just the worker
• HMRC may challenge if termination looks like retirement rather than redundancy
• PILON (payments in lieu of notice) and PENP (post-employment notice pay) rules ensure unworked notice is fully taxable

Ensuring the correct tax and NIC treatment of termination payments can feel like a minefield at times and getting this wrong can mean unexpected tax bills or HMRC scrutiny. The tax rules are quite nuanced and not as simple as just assuming the first £30,000 is tax free (although I wish I had a pound for every time I heard that!). In this blog, we’ll break down the key rules and considerations around termination payments, so you know what you need to consider when making termination payments.

What is a termination payment?

A termination payment is any payment made to an employee when their employment ends. These payments can include redundancy pay, ex gratia sums, and compensation for loss of employment. However, not all termination payments are treated the same for tax purposes.

The £30,000 exemption explained

One of the most talked-about rules is the £30,000 exemption. In short, the first £30,000 of a qualifying termination payment can usually be paid tax-free. But here’s the catch – it only applies to genuine compensation for loss of employment, not to contractual entitlements like salary, holiday pay, bonuses, or PILON. Anything above £30,000? That’s taxable and subject to Class 1A NIC (employer only).

Is it a genuine redundancy?

This is where many employers trip up. For a payment to qualify as redundancy, it’s the role that must disappear – not just the person. If you’re simply replacing the individual with someone else, HMRC won’t accept it as redundancy. A genuine redundancy means the job itself is no longer needed due to restructuring, closure, or reduced demand. It’s important to document why the role is redundant and ensure there’s no immediate rehiring for the same position. We can help review your plans and ensure the reasoning is documented clearly to withstand HMRC scrutiny.

Retirement or termination?

HMRC can also challenge payments if they believe they are for an employee retiring and not for a genuine termination. Payments made in anticipation of retirement are fully taxable and NIC-able because they’re seen as a reward for past service. If the individual moves into consultancy or another role, HMRC could argue there was no genuine termination. These challenges often arise when the payment seems linked to long service or future arrangements or is particularly generous. Typically, we would advise taking additional care where an employee’s employment is terminated and they are over 55 years old.

PILON and PENP – What you need to know

Since April 2018, all payments in lieu of notice (PILON) are treated as earnings and taxed in full. The post-employment notice pay (PENP) rules ensure that any part of a termination payment representing unworked notice is taxable. This means PILON and PENP amounts do not benefit from the £30,000 exemption. We regularly assist clients with PENP calculations to ensure they are reported correctly.

PENP calculation examples

The formula is:
PENP = (BP × D / P) – T
BP = Basic pay for the last pay period before termination
D = Number of calendar days in the unworked notice period
P = Number of calendar days in the last pay period
T = Any taxable contractual PILON already paid

Example one

Employee earns £3,000 per month, has a three-month notice period, works one month, and receives no PILON.
Unworked notice = two months. PENP = £3,000 × 2 = £6,000 (fully taxable).

Example two

Employee earns £4,000 per month, has a six-week notice period, works two weeks, and receives no PILON.
Unworked notice = four weeks (28 days). PENP = (£4,000 × 28 / 30) = £3,733.33 (fully taxable).

Example three

Employee earns £3,500 per month, has a three-month notice period, works none of it, and receives no PILON.
Unworked notice = three months. PENP = £3,500 × 3 = £10,500 (fully taxable).

Compliance checklist

✔ Identify payment components (salary, holiday pay, PILON, redundancy, ex gratia)
✔ Check eligibility for £30,000 exemption
✔ Apply PENP rules and convert notice periods into calendar days if not in whole months
✔ Review PILON treatment – all taxable
✔ Check NIC position (employee vs employer)
✔ Document reasons for each payment
✔ Update RTI submissions
✔ Consider pension contributions for tax efficiency
✔ Retain evidence for HMRC audits

How we can help

Termination payments are complex and fact-specific and both legal and tax advice should be sought when making them. We can:
• Review termination agreements before implementation
• Calculate PENP and NIC implications accurately
• Advise on tax-efficient structuring, including pension contributions
• Prepare compliance documentation to protect against HMRC challenges

Get in touch if you’d like to discuss how we can make this process smooth and compliant for you.