Payment in lieu of notice (PILON) is an issue that employers must approach with caution to avoid unwelcome tax implications should they get it wrong, according to employment lawyers Ben Stepney and Harriet Serpis.
When an employer terminates an employee’s employment, payments in lieu of notice can take three main forms:
- scenario one – those made under a PILON contractual clause entitling the employee to such a payment;
- scenario two – those made under a PILON contractual clause under which the employer has the discretion to make such a payment; and
- scenario three – those made in circumstances where there is no contractual right to pay in lieu.
Q What is the position where there is no contractual right to a PILON?
Scenario three is when it is most likely that a PILON can be paid tax free. This is because the employer is likely to be in breach of contract in terminating the employee’s employment without proper notice. As a result, the payment made to the employee is not a payment under the terms of the contract of employment, which would be taxable; instead it is an advance payment of damages, aimed at compensating the employee for the employer’s breach of contract and avoiding a potential legal claim. As long as the payment does not fall under the foreign service exemption, the payment will be tax free up to £30,000.
Consult the ‘Taxation of pay in lieu’ section in the ‘notice and pay in lieu of notice’ chapter of the XpertHR employment law manual.
Q Are payments made under a contractual PILON clause taxable?
If a payment is made automatically under scenarios one or two, because the payment is expressly contemplated by the employment contract, the PILON is usually taxable as salary in the normal way. This is because, where the employer and employee have mutually agreed that employment can be terminated early, there is no breach and so the severance payment is not regarded as damages.
Q Is the position different if the employee claims constructive dismissal?
Uncertainty can arise under scenarios one and two where the employee claims constructive dismissal because, in theory, the employer is in breach of contract and so cannot rely on the terms of the contract. As long as there is evidence of a fundamental breach it is arguable that the payment is for damages, and so would not be taxable. However, it is more often than not the case that the employer will deny the breach and the employee will effectively waive the breach so that an agreement can be reached. In this situation, the payment would be taxable.
Q What happens if the employer initially refuses to pay a PILON in scenario one and later makes a payment to the employee of a sum intended to represent a PILON?
This happened in the case of Goldman v Her Majesty’s Revenue and Customs (HMRC). The employee’s contract contained a clause that said that if the employer terminated the employee’s employment, it would “make a payment in lieu of notice within 14 days of the termination date”.
When the employer failed to pay the PILON, negotiations commenced and eventually a deal was reached and set out in a settlement agreement. Despite the employee receiving less than his contract of employment contemplated, the tax tribunal found that, because the payment was made in the light of the contractual clause and the negotiations were based upon the enforcement of the PILON clause, the sum was taxable in the normal way.
Q Can a PILON become contractual through custom and practice?
Employers need to be aware of creating an implied contractual right, or “auto-PILON”, by establishing a regular practice of making PILON payments. Employers that have a custom of making PILON payments, albeit that the contract is silent on PILON payments, are likely to run the risk of the payments being deemed to be taxable.
Q What should employers keep in mind when paying notice monies?
As a general rule of principle, notice monies are taxable, unless there is no express PILON clause in the contract of employment and an employer has not established via custom and practice a tradition of paying departing staff monies in lieu of notice. Employers that wish to pay notice monies tax free should approach with caution and, if in doubt, should double check what they are doing to avoid a tax liability.
If employers incorrectly decide a PILON payment is not taxable, HMRC has statutory powers to recover any tax and national insurance contributions, plus penalties and interest owed to it.