I've sacked a member of staff who was underperforming, with immediate effect. His contract has a clause providing an option for pay in lieu of notice. He has complained that this sum has been taxed unreasonably, claiming that the money was "compensation for loss of salary" and therefore exempt from PAYE and national insurance contributions. Is he right?
In short, no. Where an employer relies on an express right within the employment contract to make a payment in lieu of notice (PILON) rather than have the employee work it, the payment will be classed as earnings and will be subject to the usual deductions for tax and national insurance.
Under certain circumstances, a termination payment can attract a tax exemption for the first £30,000, normally where the payment represents damages for breach of contract (for example, where there is no PILON clause). Even in these circumstances, however, HM Revenue & Customs (HMRC) may still challenge the employer where there is a practice of making payments free of tax (thereby implying the contractual right to a PILON) or, separately, where PILONs are an automatic response to termination (and are not individually negotiated or considered).
In the present case, your employee is wrong in saying that the money was compensation for loss of salary. It is clearly a notice payment properly made within the terms of the contract. Compensation payments would normally be paid in addition to notice payments.
Nevertheless, you should take a careful approach when considering the taxation of termination payments (not just notice payments) and specialist tax advice should be sought where appropriate. HMRC has the power to look at payments made many years previously and, where tax should have been paid, the bill will fall to you (together with any penalties and interest), with little chance of recovery from the employee.
Scott Withers, associate, employment team, Weightmans LLP