When a termination payment is taxable in full

A recent ruling from the First Tier Tax Tribunal provides a useful illustration of how different tax provisions combine when taxing payments made under a settlement agreement. The result in this case was that income tax was due on the whole termination payment, without the taxpayer benefiting from the well-known £30,000 “exemption”.

Typically a settlement agreement provides for a number of payments that are taxable as income in the normal way – for example notice pay and accrued holiday pay. On top of that a termination payment is usually made, in return for the employee agreeing to settle any outstanding employment claims. In most circumstances such a payment will be taxable under the special tax rules applying to termination payments (see section 401 Income Tax (Earnings and Pensions) Act 2003). Essentially this means that the first £30,000 of this payment can normally be made tax free – though some adjustments may need to be made, for example in relation to “Post-Employment Notice Pay”.

However, it is not always appreciated that there is another tax provision that, when it applies, displaces the special regime that applies to termination payments. That is section 225 ITEPA, which says that payments for “restrictive undertakings” are to be taxed as income. This is not normally an issue with a typical settlement agreement for a variety of reasons – typically the relatively limited nature of obligations normally imposed solely on the employee and the way these are interpreted in practice by HM Revenue and Customs.

However, in this recent case the termination payment was very large – out of proportion to the compensation she was likely to have received if she had proceeded with the claims settled under the terms of the agreement she signed. On top of that the restrictions she agreed to accept were unusually extensive. As a result, the entire termination payment was taxable as income and the £30,000 tax exemption was lost entirely.