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In today’s challenging economy, many businesses need to cut costs, and reducing staff is sometimes the only option. When downsizing, it’s important to understand not just statutory redundancy pay but also other amounts known as termination payments. Handling these payments correctly helps avoid unexpected tax bills, penalties, and negative attention from HMRC.
HMRC Rules and Relevant Termination Awards
Termination payments extend beyond the statutory redundancy pay and may include sums for notice periods not served, settlement agreements, or special lump sums meant to compensate for job loss. HM Revenue & Customs (HMRC) refers to these as Relevant Termination Awards (RTAs). Each component of a termination package can be taxed differently. Some portions may be tax-free up to £30,000, while others could be fully taxable and also subject to National Insurance Contributions (NIC). Miscalculating these amounts can lead to significant issues, especially for companies operating under the Senior Accounting Officer (SAO) regime, where the officer is personally responsible for ensuring the accuracy of financial systems.
Calculating the Post-Employment Notice Payment
A key step is working out the Post-Employment Notice Payment (PENP), which measures how much an employee would have earned during any required notice period they’re not actually working. If an employee is owed three months’ notice and must leave immediately, the employer calculates how much salary that notice period represents. The PENP is then compared to the total termination payment minus any statutory redundancy pay. If PENP is equal to or greater than the total payment, all of that payment is treated like regular earnings and goes through payroll, incurring both income tax and Class 1 NIC in the usual way. If PENP is smaller, any remaining amount might qualify for the £30,000 exemption unless other rules require it to be taxed. However, any portion above £30,000 is still taxable and may involve Class 1A NIC, which the employer pays.
Tax and National Insurance Considerations
In most cases, a portion of a termination payment will be subject to tax or National Insurance Contributions (NIC). The key questions are how much will be taxed and which type of NIC will apply. Payments that are treated as regular wages typically incur Class 1 NIC, which is shared between the employer and the employee. In contrast, amounts exceeding £30,000 generally incur Class 1A NIC, which is only paid by the employer. Understanding when to apply Class 1 versus Class 1A is crucial for maintaining compliance with HMRC regulations.
Special Situations and Additional Complications
A restrictive covenant in a settlement agreement can create a tax liability if it includes a new restriction on the departing employee. Retirement considerations also matter because lump sums paid to older workers might be treated more like pension payments, taxed at rates as high as 45%. Salary sacrifice arrangements and pension contributions complicate the picture further, as amounts placed into a pension may affect PENP calculations. International employees can trigger foreign tax rules or treaties, which may change the amount subject to UK tax. If the company rehires an employee soon after laying them off, HMRC might question whether the termination payment was valid compensation for ending the job, which can lead to different tax treatment.
Avoiding Mistakes
Ill health may grant full tax and NIC exemptions if an employee cannot work. Certain laws also allow injury-related payments to be treated differently from regular termination awards. Given the complexity of these rules, consulting a specialist is advisable. Accurate calculations, proper documentation, and timely advice are crucial to avoiding costly errors. While downsizing is challenging, being well-prepared can help employers and employees manage the process with greater confidence and fewer financial surprises.