PILON: When can payments in lieu of notice be paid tax free?

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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. 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.