The tax rules for termination payments and disability payments was under the spotlight in the First-Tier Tribunal case of Lawrence Rawlinson v HMRC. The decision highlights a critical distinction between the reason for termination and the motive for the payment itself.

Background of the Case

Mr Rawlinson, a retired solicitor, was diagnosed with a rare form of cancer which left him unable to perform the duties of his employment. After 13 months of sick leave, his employer moved to terminate his employment, offering a settlement agreement that included two key payments: a Payment in Lieu of Notice (PILON) of £15,000 and a separate termination payment of £15,000. It was noted that there was no contractual PILON in Mr Rawlinson’s employment contract, neither did one arise from an existing custom or practice.

The termination payment was paid tax-free and was not in dispute. The PILON, however, was subjected to PAYE deductions (tax and National Insurance contributions) by his employer, which Mr Rawlinson challenged. He argued the entire PILON amount should be tax-exempt under s.406(1)(b) as a payment made “on account of” his disability.

The Legal Framework: Priority and Exemptions

The Tribunal had to navigate the hierarchy of tax legislation (p. 6):

1. General Earnings Charge (s.62): Tax on standard salary, wages, and benefits
2. Termination Payments Regime (s.401): Applies to payments made in consequence of employment termination, unless they are already covered by s.62.
3. Disability Exemption (s.406): This exempts payments made on account of injury or disability from the s.401 regime, potentially making them fully tax-free

The core issue was whether the s.406 exemption could override the general taxability of the PILON as a “post-employment notice pay” (PENP), as s.406 disapplies the entire termination payments chapter.

The Tribunal’s Decision

The Tribunal made two key findings on the tax issue:

• PILON was not s.62 earnings: The PILON was agreed upon as part of the termination process itself, it was not an existing contractual right, so it did not fall under the general definition of earnings. This meant it fell into the s.401 termination payments regime, making the s.406 exemption potentially relevant
• Disability exemption did not apply: The leading case of Hasted v Horner set the test to qualify for the exemption; there are two limbs to meet “there must be established as an objective fact a relevant disability and as a subjective fact that the disability is the motive for payment”. The Tribunal distinguished between the reason for termination (which it was accepted that his disability was the undisputed cause of his employment ending) and the motive for the payment. The judge found the motive for the PILON payment was to discharge the employer’s legal obligation to provide notice. The payment would have been due regardless of the reason for termination. Therefore, as it was not made “on account of” the disability, it failed the s.406 test and remained taxable under the s.401 regime.

This case serves as a crucial reminder for both employers and employees to clearly document the specific reasons for any termination payments within settlement agreements. We can provide a review service for settlement agreements to provide guidance and advice on the risks associated with relying on a tax exemption. Please get in touch with us to find out more.