UK Employment Alert No. 134: Taxation issues when paying in lieu of notice
March 23, 2007
Background
UK legislation allows the first £30,000 of a payment to be paid tax free where that payment is made “in consideration of, in consequence of, or otherwise in connection with” the termination of employment or a change in duties or earnings.
Such payments are most common when an employer and employee enter into a compromise agreement. However, when a payment in lieu of notice (PILON) is made as part of the termination arrangements, the question arises whether it can be paid tax free or whether it is a payment made under the contract of employment and so fully taxable.
The recent High Court case of SCA Packaging Ltd v HM Customs & Excise reminds us of the limited circumstances in which a PILON can be paid free of tax.
The facts
SCA made a number of employees redundant between 1996 and 2001, on terms which included an untaxed termination payment. There was no PILON clause in the employees’ contracts of employment. However, SCA had entered into a written redundancy agreement with the union, which provided for an ex gratia payment plus a sum in respect of notice.
HMRC considered that the PILON payments were a contractual entitlement and taxable as they were derived from the the employees’ employment. SCA appealed.
The Decision
The Special Commissioners and the High Court both agreed that the payments in lieu of notice resulted from a prior agreement (either between the employees and SCA or between SCA and the union).
As a result, the payments were fully taxable.
What this means for employers
This case is a useful reminder to employers of three key points:
- When considering whether a PILON is a contractual entitlement, employers should not restrict themselves to looking at the contact of employment. Entitlement to be paid in lieu could be contained in another document, such as a collective agreement or a redundancy policy. This collateral document may be entered into further to the negotiation of termination terms.
- Even if there is no express contractual PILON clause, a right to be paid in lieu may be created through custom and practice. If employees are always, almost automatically, paid in lieu of notice HMRC may consider these payments to be taxable.
- It is always helpful to include a tax indemnity from the employee in a compromise agreement. Although these will not always be cost effective to enforce, they do give the employer the option of passing any additional tax liability on to the employee.
