If an employer pays an employee in lieu of notice, is the payment taxable?
Where a payment in lieu of notice is made on or after 6 April 2018, in respect of employment that terminated on or after that date, the payment is subject to tax and national insurance. Provisions in the Finance (No.2) Act 2017 change the rules on the taxation of termination payments to remove the distinction between contractual and non-contractual payments in lieu of notice. The tax exemption on payments under £30,000 will no longer apply to any payments in lieu of notice made under the new rules. The employer must calculate what the employee's basic pay would have been had he or she worked the notice period, using a formula set out in the legislation. Where a termination payment is greater than this amount, the £30,000 exemption can apply to the remainder.
Under the previous rules (which still apply where the termination date was before 6 April 2018, even if the payment is made after that date), 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 represents 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.