If an employer pays an employee in lieu of notice, is the payment taxable?

Whether or not a payment in lieu of notice is taxable depends on the terms of the employee's contract. If the contract of employment contains an express clause allowing the employer to pay the employee in lieu of notice, the payment will represent wages and will, therefore, be subject to tax and national insurance contributions. If the contract of employment does not contain an express payment in lieu of notice clause, but the employer's custom and practice is always to pay in lieu, such a term may be implied into the contract of employment and any resulting payment in lieu may be taxable. However, if there is no payment in lieu of notice contract clause, and there is no risk of there being one implied, the payment will be regarded as compensation for a breach of contract (the failure to give the employee his or her contractual notice) and the first £30,000 will be tax free.

Where a payment is regarded as compensation, the question arises of whether the employer should pay the net or gross sum to the employee. Strictly speaking the employer is obliged to pay the employee only the net amount to represent the amount that he or she would have received but for the breach of contract by the employer.

However, many employers will make a gross payment to the employee as a gesture of goodwill. After all, if the employer had dismissed the employee without breaching the contract, the employer would be out of pocket to the same extent; it would, however, have paid the tax to HM Revenue & Customs.

Changes to the rules on taxation of termination payments will come into force on 6 April 2018. Under provisions in the Finance (No.2) Act 2017, all payments in lieu of notice, whether contractual or not, will be subject to tax and national insurance. The £30,000 exemption will not apply to any payments in lieu of notice. The changes will affect payments made on or after 6 April 2018 in relation to terminations that take place on or after that date.