There is no doubt that not every employer understands when, how or at what rate they should tax a termination payment an employee receives under a settlement agreement or Acas COT3.

In such a complicated area, we set out the basic points taking into account the changes to National Insurance that are on their way.


Since April 2018, the amount of basic pay that an employee would have received if they had worked their notice in full, is subject to deduction for employee’s income tax. If both employee and employer’s Class 1 National Insurance contributions are payable on payment in lieu of notice.

The changes to the law mean that even if the contract of employment does not contain the discretion to pay in lieu of notice, it will still be liable for tax.


 Settlements will often include a payment in addition to the salary, notice pay and holiday pay someone is owed. Should they be taxed?

Section 62

The starting point is to consider whether the payment, or any part of it, falls to be taxed as employment income (under section 62 Income Tax (Earnings and Pensions) Act 2003 “ITEPA”). The question to be asked is: is the payment or benefit earnings from the employment?

If it is (and even if it is called compensation for termination), if it relates to services rendered it will be fully taxable under section 62. Likewise payments which constitute earnings from employment attract employer’s and employee’s National Insurance contributions.

Section 401

Where no other charging provision (such as section 62) applies, Section 401 IEPTA provisions on termination payments apply. These provide that lump sum payments made in connection with the termination of the holding of an office or employment are subject to income tax subject to the limited exceptions. The most relied on exception is that the first £30,000 of such a payment qualifies for tax and NI exemption.

Amounts above £30,000 attract income tax at the employee’s usual rate-  but currently not National Insurance, as payments within sections 401 to 416 of ITEPA 2003 are not “earnings” for NICs purposes and are therefore not generally liable to NIC.

Upcoming changes to the NIC treatment

Originally designed to come into effect at the same time as the reform of the tax treatment of PILONS in April 2018, the changes are now on track to come into play on 6 April 2020.

From then, by virtue of the National Insurance Contributions (Termination Awards and Sporting Testimonials) Bill 2017-19 which were introduced into Parliament on 25 April this year, Class 1A (employer’s only) NICs will also apply to a termination payment which is taxable for income tax, to the extent that it exceeds £30,000. The applicable rate will be payable at 13.8%. Employee contributions will not be required. This will represent a substantial additional cost for employers where Settlements exceed £30,000.


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