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Change to taxation of payments in lieu of notice (PILONs) with effect from 6 April 2018

It is common for contracts of employment to provide that both the employer and the employee must give each other a set period of notice of their intention to terminate the contract. For example, the contract could state that either side should give the other three months’ notice of their intention to terminate.

If there is no written contract document, or there is a contract document but it does not state the relevant notice periods, then the common law (law based on judicial decisions made over the years) provides that each party shall give the other “reasonable” notice.  What the law considers reasonable will depend upon a range of factors such as the seniority, length of service and particular circumstances of the employee, and may vary significantly between employees.  On top of that, the Employment Rights Act 1996 sets out certain minimum periods of notice to be given by either side.  In the case of the employer, there is a statutory minimum period of one week’s notice to be given for each complete year of service, up to a maximum of 12 weeks’ notice after 12 years’ service.  The statutory minimum notice period overrides anything shorter which may be contained in the contract.  In cases of gross misconduct, the employer is normally entitled summarily to dismiss the employee (i.e. without notice).

When one or both parties wish to bring to an end an employment relationship, some employers will prefer that the departing employee does not attend work any longer, perhaps because the employer feels that the employee may pose a threat to staff morale, or even to data security.  Such employers might therefore decide to end the employee’s employment immediately.  Others may tell the employee to stay away from the premises but remain an employee until the expiry of the notice period - in other words they will pay the employee to stay at home.  Yet other employers may require the employee to work all (or some) of their notice period.

In any scenario where the employer does not want the employee to remain on the premises, normal practice is for the employer to make a payment in lieu of notice (PILON) to the employee, in a sum equivalent to what they would have earned had they worked their notice period. 

In the House of Lords case of Delaney v Staples [1992] Lord Browne-Wilkinson identified four categories of PILON:

  • Category 1: the employer gives contractual notice of termination to the employee, telling them that they need not work until the termination date and paying them their wages/salary for the notice period in a lump sum.
  • Category 2: the employer relies upon a clause in the contract allowing it to dismiss the employee summarily and make a PILON.
  • Category 3: at the end of the employment, the employer and the employee agree that the employment shall end forthwith on making a PILON.
  • Category 4: without the agreement of the employee, the employer summarily dismisses the employee and makes a payment in lieu of the proper contractual notice it should have given.

Tax treatment of these categories by Her Majesty’s Revenue & Customs (HMRC) prior to 6 April 2018:

  • HMRC would always treat the first two categories above as payments made pursuant to the contact of employment and, therefore, as taxable earnings.
  • HMRC would treat the third category as a payment made pursuant to the contract of employment if the employer and employee reached agreement prior to the termination date.
  • The fourth category would be treated in effect as damages (compensation) paid by the employer to the employee for breach of contract in failing to allow the employee to work their contractual notice period.  Because the payment was treated as damages for breach of contract, as opposed to a contractual payment, the employee could benefit from the £30,000 tax exemption.  (In addition, the payment was potentially not subject to any national insurance contributions).

From 6 April 2018, following a change to sections 402 to 404 of the Income Tax (Earnings and Pensions) Act 2003, there will be practically no difference between HMRC’s tax treatment of “contractual PILONs” (categories 1 to 3 above) and “non-contractual PILONs” (category 4).  HMRC will generally treat both types as fully taxable (and subject to national insurance contributions).  Although the technical distinction between contractual and non-contractual PILONs will remain, it will have little practical significance. 

In cases where the parties decide to enter into a settlement agreement, employers will have to differentiate clearly in the agreement between that element of the termination payment to be treated as taxable earnings (for example any PILON, holiday pay or contractual bonuses) and that element which can benefit from the £30,000 tax exemption (for example, the first £30,000 of any redundancy payment). 

Following these tax changes, some employees may lose out to the tune of several thousands of pounds, by having to pay tax on what had previously been received tax-free.  This may justify employees seeking to negotiate a higher overall termination payment than would otherwise have been the case.

The new regime will apply only where the termination of employment itself occurs on or after 6 April 2018.

If you would like any additional information regarding the content of this article please contact David Ellis, Associate Solicitor on 01905 721600

 

 

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