Changes to the taxation of PILON payments

Where an employer and employee wish to bring their contractual relationship to an end, notice is usually required in order to lawfully terminate the contract of employment. However, in certain instances, a termination payment may be made and the employee will not be required to work his or her notice period. This can be advantageous in certain circumstances, for example, where the relationship with the employee has broken down and it would be impractical for them to continue working with the employer.

Termination payments – is there a PILON clause in the contract of employment?

Elements of a termination payment which relate to the amount of notice pay due to an employee can be either contractual or non-contractual. A contractual termination payment requires the inclusion of a payment in lieu of notice (PILON) clause in an employee’s contract of employment. Employers may choose to include a PILON clause as this grants them the contractual option to make a termination payment as an alternative to the employee working their notice period. This termination payment is owed as a debt to the employee under the contract of employment and the employee does not owe the employer any credit for the payment (i.e. the employee does not need to work their notice for the payment).

Where a PILON clause is not included in the contract of employment and a non-contractual termination payment is made, the payment will be treated as damages for breach of contract. Depending on the other clauses contained in the contract, this can be unattractive as the employer will then not have the option to enforce any restrictive covenants included in the contract and, for example, the employee may then have the option to work for a nearby competitor or solicit and deal with the employer’s current clients. This could have a detrimental impact on the employer and thus it is desirable for employers to include PILON clauses in their employees’ contracts of employment to ensure, where a termination payment is made, there will be no breach of contract and any restrictive covenants will remain in place between the parties.

Taxation on PILON payments – the current position

The tax treatment of contractual and non-contractual termination payments significantly differ at present. If a contract of employment includes a PILON clause and the employer exercises its right to grant a termination payment at the end of the employee’s employment, that payment is subject to tax and national insurance contributions (NICs). If there is no PILON clause and the employer grants a termination payment to the employee at the end of the employment, the first £30,000 can be paid tax-free. Any amount above this threshold is taxable, however no NICs are due.

This position is set to change from 6 April 2018 as a result of the government’s proposed reforms to the tax and national insurance contributions of termination payments.

Taxation on PILON payments – the position from 6 April 2018

From 6 April 2018 the tax treatment of termination payments will change and will effectively bring the taxation of contractual and non-contractual PILONs in line with one another. The intention of these reforms is to ensure that the basic pay an employee would have earned had the employee worked his or her notice in full will be subject to tax (any amount above this may benefit from the £30,000 exemption).

The reforms will therefore require employers to identify the amount of basic pay that the employee would have received if they had worked their notice period and to split a termination payment between (1) amounts treated as earnings and (2) amounts which are being paid in true compensation for loss of employment and which may benefit from the £30,000 threshold for tax exemption.