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Guide to Unfair Dismissal and Taxation of Awards

Unfair dismissal awards are made under section 118 of the Employment Rights Act 1996 and comprise:

 A Basic Award, calculated according to the employee's age, years' service and pay, and subject to a cap on the level of pay that can be taken to account. For terminations on or after 1 February 2011 the cap is set at £400 a week (£380 a week for dismissals from October 2009 and 31st January 2011).

 A Compensatory Award, of an amount that the tribunal considers ‘just and equitable’ in all the circumstances having regard to the loss sustained by the employee. This award is subject to a cap, currently set at £68,400 (£65,300 for dismissals from 1st February 2010 to 31st January 2011).

 The tax treatment of an unfair dismissal award is as follows:

Awards of £30,000 or less

The Basic Award is treated as falling within the £30,000 tax-free band under Section 401 of Income Tax (Earnings and Pensions) Act (ITEPA) 2003.

 The Compensatory Award (subject to the cap of £68,400) should also be taxed under section 401 because it is a payment received in connection with the termination of employment. However, the Basic Award and Compensatory Award should be aggregated.  If the Compensatory Award (when aggregated with all other termination payments) still falls within the £30,000 tax-free band, there will be no tax charged.

Awards greater than £30,000

Where the combined sum of the Basic Award and Compensatory Award is greater than £30,000, the tribunal will have to add the sum that is deductible for tax back onto the award to cancel out the tax burden imposed on the employee. This is done by:

  1. Calculating the employee's loss based upon the net value of salary and benefits (i.e. after tax and National Insurance Contributions) to be compensated.
  2. Deducting any part of the £30,000 exemption that remains available.
  3. Grossing up the resultant figure to reflect the tax due from the employee on the excess over £30,000. The amount should be grossed up at the employee's marginal rate (20% for lower rate tax payers, 40% for higher rate). 
  4. Adding the grossed-up figure to the compensation.

Awards greater than £68,400

There is no official guidance in cases where, if the employee's net loss, once grossed up, exceeds the current maximum Compensatory Award of £68,400. The consensus however, is that the tribunal should award the maximum and the employer should deduct PAYE (at the appropriate percentage rate) on the excess over £30,000 before making the payment to the employee.

For more information contact our Employment Law Team

By Martin Williams