Lump sum payments on termination of employment before retirement are, with exceptions, liable to income tax. The main exception is that the first £30,000 is normally tax exempt (Income Tax (Earnings and Pensions) Act 2003 ss.403 and 404, previously ICTA 1988 s.148). However, even that will be taxable if the employee was contractually entitled to it (see EMI Group Electronics Ltd v Coldicott (HMIT) CA 1999 IRLR 630, CA) or if it counts as a payment from an unfunded non-approved pension scheme.

It will be seen from this that the common belief that an employee is automatically entitled to the first £30,000 of such payments tax free is wrong. The true position is that it depends on the facts of the individual case.

In 2008 there was a good example of a case in which the issues involved were considered in detail. The Special Commissioner decided in favour of the tax payer that an ex-gratia payment to an employee was covered by the £30,000 exemption noted above and was not taxable as earnings (Resolute Management Services Ltd (formerly Equitas) v HMRC SPC710 on 27th August 2008).

The other main tax free lump sum payments (unlimited) on termination of employment are:

a) lump sum payments in respect of long foreign service.
b) lump sum payments on account of death, injury or disability.
c) lump sum payments from pension schemes (other than unfunded unapproved pension schemes).
d) a reduction in respect of foreign service.

Settlements of cash awards made by employment tribunals are treated in the same way. An amount equal to tax which would have otherwise been payable is thus deducted in calculating the first £30,000, so the employer normally benefits from the reduction.

Liability for NI Contributions follows tax liability. A tax exempt lump sum is normally also exempt from NIC (see the section on "payments linked to leaving" in the DSS "National Insurance Contributions Manual for Employers").

A payment to an employee without deduction of PAYE tax which should have been deducted can be treated for tax purposes as though tax had been deducted. The employer can therefore be required to pay PAYE tax on the grossed up equivalent of the amount paid. A prudent employer will therefore always seek clearance from his local Tax Office and DSS office before making a tax free lump sum termination payment.

Going abroad for the tax year in which a termination payment is received will not exempt it from tax (Nichols v Gibson 1996 CA, TLR 9th July 1996).