A taxing time for PILONs

“Does the employment contract contain a PILON clause?” The question often asked by employment lawyers of their clients when drafting Settlement Agreements to be issued to a departing employee. The PILON in question is of course a payment in lieu of notice clause.

If a contract of employment contains a PILON clause then generally speaking a payment in lieu of notice to the employee whose contract is being terminated should be subject to tax and national insurance deductions. This is because HMRC view the payment as being made pursuant to the terms of the contract (the PILON clause) and is therefore an emolument of employment subject to tax in the ordinary way. If the contract does not contain a PILON clause then technically speaking paying in lieu of notice is a breach of contract and the resulting payment is damages for breach of contract in connection with the termination of employment. As such it can form part of the £30,000 tax free exemption for certain termination payments.

There has been a separate debate about whether PILONs can be implied through custom and practice (the so-called “auto-PILON”) where the employer invariably chooses to make a payment in lieu of notice on termination. I have never thought much of this argument, not least because it rarely meets the established tests from the case law for terms to be implied by custom and practice, and it is not a debate I intend to prolong. In fact, I don’t need to because the government are intending to legislate to make it a moot point.

In July 2015, the government launched a consultation on how termination payments are treated for the purposes of tax and National Insurance contributions (NICs). It has now published its response to the consultation together with draft legislation designed to implement the changes it has decided to make. These changes are expected to become law in April 2017 but are not due to take effect until April 2018.

The consultation confirms that the government will remove the distinction between contractual and non-contractual PILONS (so that all payments in respect of the notice will be treated as earnings subject to income tax, employer NICs and employee NICs, regardless of whether there is an express PILON clause).

The consultation response also confirm that the government intend to retain the exemption from income tax and employers’ and employees NICs for payments relating to termination up to the current threshold of £30,000 which will be a relief for employers I am sure. However they will be aligning the rules for income tax and employers’ NICs so that employers’ NICs will be payable on payments above £30,000. At the moment, whilst income tax is payable on the amount of the compensation payment over £30,000, NICs are not payable. In addition, legislation will expressly exclude payments for injury to feelings from the exemption for injury payments, except where this amounts to a psychiatric injury or a recognised medical condition.

These changes should all serve to simplify the taxation of termination payments, although not completely. There may be genuine circumstances where an employee’s employment is being terminated either on grounds of gross misconduct or otherwise where a summary dismissal has taken place or would be justified. In that scenario there may still be ambiguity over whether any termination payment is damages for an (alleged) breach of contract or is a PILON. No doubt the amount of the payment will be relevant.

The practical consequence is that there appears no real reason why an employer would not wish to include a PILON clause in their contract of employment, because not having one will no longer provide tax flexibility. There are a few benefits to including a PILON clause in the contract. First and foremost it allows a company to pay in lieu of notice without breaching the employment contract, which in turn preserves post-termination restrictive covenants, and prevents an employee seeking to reject and affirm the employer’s breach. It also allows the employer to define in advance what salary, benefits and holiday pay are to be included and not included within the PILON.

I will continue to ask my clients whether the contract in question contains a PILON clause but in future this will be for more subtle, and less taxing, reasons.