The injury and disability exemption on termination

Section 406(1)(b) of ITEPA 2003 takes a payment or benefit made on account of injury to, or disability of, an employee outside the termination payment rules altogether, so it is free of income tax with no £30,000 limit. HMRC accepts the exemption only where medical evidence shows a condition that stopped the employee doing the duties of the job at the point of termination, and the payment was made for that reason and nothing else.

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What does section 406 exempt?

Chapter 3 of Part 6 ITEPA taxes payments connected with the termination of employment, or with a change in duties or earnings, above a £30,000 threshold (sections 401 and 403). Section 406(1) says that Chapter does not apply to a payment or other benefit provided in connection with termination by the death of an employee, or on account of injury to, or disability of, an employee. Because the whole Chapter is switched off, the payment does not use up the £30,000 and there is no ceiling on the exempt amount. HMRC says at EIM13635 that size is of itself no bar to the exemption.

HMRC’s guidance at EIM13610 applies the exemption to payments on a change in duties or earnings as well as on termination. It also notes that the injury or disability normally causes the termination, but the exemption can still be due where it does not, provided the payment is made in connection with the termination and solely on account of the disability.

What counts as injury or disability?

Injury means physical or psychological injury. Section 406(2), which has effect from 6 April 2018, confirms that injury includes psychiatric injury but not injured feelings. Compensation for distress in a discrimination claim is therefore dealt with separately, as explained in are injury to feelings awards taxable.

Disability is defined in Statement of Practice 10/1981, set out at EIM13620. It means an incapacity to fulfil the duties of the office or employment caused either by a sudden affliction, such as a heart attack, or by the culmination of a process of deterioration of physical or mental health caused by a chronic illness, such as chronic fatigue syndrome. It does not include the normal processes of ageing. HMRC adds that if an employee has a heart attack, returns to work and is paid on leaving at a later date, the payment may not be due to the disability; only the reason for the payment counts.

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What are the two tests HMRC applies?

The High Court in Hasted v Horner (67 TC 439) set two tests, both of which must be met (EIM13630):

A disabling medical condition. There must be an identified medical condition that prevents the employee from carrying out the duties of the employment. Medical evidence confirming the precise nature of the disability must be seen in all cases, and it must be clear that it prevented the employee carrying out the specific duties of the job.
The sole reason for the payment. The payment must be made on account of that disability and nothing else. If the employer did not know of the disability when the employee left, the payment cannot be on account of it. If any part rewards specific services, or would be due on termination whatever the cause, that part does not qualify.

HMRC also stresses timing. Where the condition caused the termination, the medical position and its effect on the job are judged at the point of termination, so evidence of a condition two years earlier is not determinative.

What medical evidence does HMRC expect?

The manual does not prescribe a form, but the tests tell you what the evidence has to show. In practice that means a report from a doctor, consultant or occupational health adviser, dated close to the termination, that:

names the condition or injury rather than describing symptoms in general terms;
explains how it prevents the employee doing the specific duties of the role, not just work in general;
gives a view on prognosis, so it is clear the incapacity is not a short episode the employee has recovered from.

HMRC says it is frequently necessary to see all the documentation to establish why the employer paid. Board minutes, the dismissal letter and the settlement agreement should all point to the disability as the reason. A settlement agreement that describes the payment as compensation for loss of office, with a medical report attached as an afterthought, undermines the claim.

What if the agreement also settles other claims?

The exemption needs the payment to be wholly on account of disability. HMRC’s guidance at EIM13637 gives two common problems. First, if the contract provides a payment on termination for any reason, that payment is earnings under section 62 even where disability triggers it (Dale v De Soissons). Second, a settlement agreement that settles all claims also settles claims such as unfair dismissal. Part of the payment then relates to those claims and falls within section 401 without the section 406 exemption. The split is made on a just and reasonable basis.

Other charges also take priority. Section 401(3) says the termination Chapter does not apply to anything taxable elsewhere, so salary, holiday pay and contractual sums are taxed as earnings first, and a payment on retirement may be a relevant benefit under an employer financed retirement benefits scheme (section 394). Ill health lump sums from a registered pension scheme are dealt with by section 407 rather than section 406 (EIM13660).

What does a typical qualifying case look like?

HMRC’s own example at EIM13635 involves an employer insurance policy that pays the employer monthly during an employee’s sickness absence, passed on to the employee and taxed as sickness pay under section 221. When medical reports show the employee will never return, the insurer commutes its liability into a lump sum, which the employer pays to the employee as part of an agreement ending the employment. That lump sum is the typical disability payment.

Illustration only. A warehouse supervisor suffers a back injury. A consultant’s report, dated a month before the employment ends, says he can no longer perform the lifting and driving duties of the role. The employer terminates the employment and pays:

Element	Amount	Treatment
Accrued holiday pay	£2,000	Earnings, taxed under PAYE
Compensation on account of the injury	£60,000	Exempt under section 406(1)(b)

The £60,000 is free of tax and does not use the £30,000 threshold. If the agreement had also settled an unfair dismissal claim the employee had lodged, part of the £60,000 would be apportioned to that claim and taxed under the normal termination payment rules.

Is National Insurance due?

Employer Class 1A on termination awards applies to amounts above £30,000 taxed under section 403, and it mirrors the income tax rules (NIM13201). A payment that section 406 takes outside the Chapter is not taxed under section 403, so no Class 1A arises on it. Earnings elements such as holiday pay still attract Class 1 in the normal way. See National Insurance on termination payments.

What mistakes come up most often?

Relying on a fit note or a vague letter instead of evidence that links a named condition to the specific duties.
Using evidence that is out of date at the point of termination.
Claiming the exemption for a payment the contract required on any termination.
Rolling disability compensation into a general settlement of all claims without attributing it.
Treating stress or anxiety as exempt without a diagnosis; psychiatric injury qualifies, but injured feelings do not.

Large exempt payments attract attention in an employer compliance check, so the file should show the medical evidence and the reason for payment from the outset. Our page on settlement agreements covers the other elements of a leaving package.

If HMRC opens a check into your return, tax investigation insurance pays your accountant’s fees. Solar Protect cover pays up to £100,000 with no excess; it never pays tax, interest or penalties. Read how our cover works or get a quote.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 24 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.