Payments and tax

Some settlement payments are tax-free (up to £30,000), while salary, holiday pay and notice pay are taxed in full under the PENP rules. It’s what you keep in your pocket that counts. A settlement package might look generous, but once HMRC takes its cut, the amount you keep can shrink fast.

What settlement amounts can be paid without tax?

The main relief is the £30,000 income-tax exemption in section 403 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) for ‘termination awards’ (as defined in section 402A(1)), where the payment isn’t otherwise taxable. The relief can be enjoyed for:

• non-contractual redundancy pay

• genuine ex gratia compensation for loss of employment

The £30,000 tax exemption isn’t an annual allowance; it applies per employment termination, not per tax year.

The key test is whether the payment is contractual. If you were already entitled to it under your contract (in whole or in part), it’s fully taxable as ordinary earnings, whatever label is used. Even if it’s described as “compensation”, HMRC will tax it if it’s contractual in substance.

Before signing, ask yourself: what is the payment really for, and is it genuinely a goodwill payment outside your contract?

What payments are always taxed?

Some payments are taxable no matter what label is used to describe them. These include:

• normal salary

• accrued holiday pay

• contractual bonuses or commission

• pay in lieu of notice (PILON)

PILON is an acronym, not as painful or electrical as it sounds. It means your employer ends your employment immediately but pays you for your notice period instead of making you work it.

Since April 2018, all notice pay, however it’s described, is taxable under the Post-Employment Notice Pay (PENP) rules, introduced into ITEPA 2003 to close the old loophole where employers could roll all notice pay into the tax-free £30,000 if the contract was silent on PILON.

The PENP rules

PENP is calculated by the statutory formula in section 402D ITEPA 2003:

PENP = ((BP × D) ÷ P) − T (and if the result is negative, it’s treated as zero)

where:

• BP = your basic pay for the last pay period before your employment ends (no bonuses or overtime)

• D = the number of calendar days in your notice period that weren’t worked

• P = the number of calendar days in your last pay period (for example 30 if you’re paid monthly)

• T = any taxable termination payments already made that relate to the same period

Essentially, the formula isolates the amount that represents unworked notice, and that part is fully taxable.

Example: Pippa’s PENP

Pippa earns £3,000 a month, has a three-month notice period, and is paid monthly (P = 30 days). Her employment ends immediately, and she has no prior taxable termination payments (T = 0).

PENP = ((£3,000 × 90) ÷ 30) − 0 = £9,000

That £9,000 counts as Pippa’s taxable notice pay. It’s treated as ordinary earnings, so tax and National Insurance are deducted in full.

While the above example is straightforward enough, calculating PENP (pronounced as a word just as PILON is, but a little more painful for employees) can be tricky, especially if your salary and notice period don’t line up neatly. The concept is simple: anything that represents pay for the notice period (including PILON) is now fully taxable, and that’s where the pain lies.

The best way to avoid an unpleasant surprise is to be clear about the time period covered by your payments. If any payment lines up closely with your notice period or your normal pay, HMRC will almost always treat it as taxable notice pay, so check carefully before you sign.

Tips on identifying your notice period

Before you can work out what counts as notice pay, you need to know your notice period. Here’s how to check it.

Check your contract first

Most contracts spell it out clearly, often under “Termination” or “Notice.” It might say “either party must give one month’s notice” or “the employer must give three months.” That’s your contractual notice period.

If there’s no written term, use the legal minimum

By law, you’re entitled to at least one week’s notice after one month’s service, plus one extra week for each full year you’ve worked, up to a maximum of twelve.

Watch for different notice lengths

Some contracts give the employer a longer notice period than you. For PENP, HMRC uses the employer’s minimum notice period, not yours.

Account for any holiday or garden leave

If you’re being paid but not working during garden leave, that time still counts as notice and affects how PENP is calculated.

Example: Noah’s notice pay

Noah’s contract says he’s entitled to three months’ notice. His employer puts him on garden leave from 31 March, and his employment formally ends on 30 April. That means one month of his notice period is worked during garden leave, leaving two months unworked. Those two unworked months count as PENP, in other words, taxable pay for notice not worked by Noah.

Why that PILON clause can still matter (and it has nothing to do with tax)

A PILON clause, where your contract allows your employer to pay you in lieu of notice and end your employment straight away, can still matter contractually, even though it no longer affects tax.

Here’s why. Suppose your contract includes post-termination restrictions (like non-compete or non-solicitation clauses, often called PTRs). If your employer ends your job without a PILON clause, that’s technically a breach of contract. When that happens, those restrictions fall away, meaning your employer loses the very protections they made you sign up to.

So, if your contract contains PTRs, don’t be surprised if it contains a PILON clause too. Even after the PENP rules changed how notice pay is taxed, employers still include a PILON option to make sure their post-termination restrictions remain enforceable. A valid PILON avoids a repudiatory breach and keeps those restrictions alive.

Can pension payments reduce the tax bill?

Yes. Some employers will agree to pay part of your settlement directly into a registered pension scheme. This is often the single biggest tax-saving opportunity in a settlement because employer pension contributions (often described in agreements as a section 408 pension contribution) are tax-free under section 307 of ITEPA 2003 and expressly excluded from the termination payment rules in sections 401 to 403 (thanks to section 408(1)(a)).

If you can afford to forgo taking a portion of the settlement right now (and not everyone is fortunate enough that they can), you could avoid income tax and National Insurance even if you’ve already used your £30,000 exemption.

But just because it’s allowed under section 408 of ITEPA doesn’t mean HMRC will take the day off. To qualify as a genuine employer contribution, the payment must:

• be shown as a separate line in the settlement agreement

• be paid directly to the pension scheme, not via your bank account

• be accepted by a registered scheme as an employer contribution; and

• not be used to disguise or “wash” ordinary earnings

Such payments are usually made on or before the termination date, while you’re still employed, because that timing avoids post-employment complications. However, there’s no absolute legal rule that they must be paid before termination. The key is that they’re clearly drafted, genuinely employer-funded, and properly itemised so HMRC recognises them as section 408 contributions.

Your solicitor can check that the contribution is clearly worded and itemised so HMRC recognises it as a genuine section 408 payment. This option is particularly useful if you’re nearing retirement or want to top up your pension pot, but it isn’t always straightforward. Check your annual allowance and the limits on tax-free lump sums (the Lump Sum Allowance and Lump Sum and Death Benefit Allowance), as large contributions can still trigger extra tax charges. If those allowances are tight, or you’re wondering what any of this means, get tax advice first.

In short, if you’re in a happy place where you can afford it, redirecting part of your settlement into your pension can be one of the safest and most tax-efficient ways to reduce your overall bill, as long as it’s structured properly.

Why structure matters

Tax on settlement agreements is as much about structure as it is about rates. Even small drafting slips, like calling a PILON “ex gratia,” can draw HMRC’s attention and lead to backdated tax. Label each payment for what it truly is; HMRC taxes substance, not form.

A well-drafted agreement will:

• describe each payment clearly

• separate taxable and non-taxable sums

• avoid vague or confusing wording

We already mentioned getting tax advice in the context of pensions. Similarly, if your package includes share options, deferred bonuses, long-term incentives or overseas work, getting specialist tax advice alongside your solicitor’s review can make a big difference when the sums are large.