Currently, PILONs are subject to tax and National Insurance contribution deductions if they are contractual (or customarily paid on termination). Such payments are, however, payable tax-free if they are non-contractual and therefore essentially being paid as damages for loss of notice and breach of contract.
However, from 6 April 2018, all PILONS will be treated as taxable “earnings”, irrespective of whether they are contractual or non-contractual, and will be subject to tax and National Insurance contributions. It will therefore no longer be possible to agree an early termination, forego part or all of the notice period, and treat the equivalent of the notice pay as a tax-free compensation payment. Employers must treat the proportion of a termination payment, which reflects basic pay for any part of a notice period that is not served, as earnings subject to tax and National Insurance contributions.
A “termination payment” is any payment that is not already chargeable to income tax and does not include contractual payments (such as salary, holiday pay, bonuses) or, payments made as consideration for entering into new obligations such as restrictive covenants, all of which are taxable in full. Termination payments are tax-free up to a threshold of £30,000 and this will include any redundancy payment. The excess of any termination payment over this threshold is taxable.
Normal termination payments will continue to benefit from the £30,000 tax exemption, but the new category referred to as “post-employment notice pay” will be excluded from the exemption. Employers will therefore need to carefully separate out the various elements of the payments made on termination of employment.
In cases where the only payment made to the employee is a PILON, it will be subject to tax and National Insurance contributions and will not benefit from the £30,000 tax-free exemption. However, if the termination payment includes additional payments the employer will have to calculate which element is taxable, and which is not.
This will involve identifying any notice payments that the employee would have received if they had worked their notice period (irrespective of whether there is a PILON clause in the contract of employment or not), as these will be taxable. HMRC will assume that any termination payment will include post-employment notice pay if the employee is not required to work their full notice (either contractual or statutory).
The new rules relate to circumstances where employment is terminated, and the termination payment is made, on or after 6 April 2018. This should be borne in mind when negotiating settlement agreements immediately prior to this date. Any PILONs paid on or after this date, for employment which terminated on or after this date, will be subject to tax and National Insurance contributions and may therefore be more costly for employers.*
In light of the new rules, employers whose employment contracts do not already contain a PILON clause may wish to consider revising these to include a contractual PILON. This is particularly important if the contract contains restrictive covenants, as these will cease to be effective post-termination if the employer pays in lieu of notice, in breach of contract, on termination of employment.
In summary the main practical consequences of these new rules are:
- If you are negotiating a termination package where there is no contractual PILON termination will have to take place before 6 April if you want to pay the PILON tax-free;
- It is no longer going to be possible to agree an early termination and to treat the PILON as compensation;
- There will be no longer be any advantage to not having a PILON clause in your contracts of employment;
- In future you may end up paying more to conclude settlement negotiations because the notice pay will always be taxable.
*This article was updated on 21 March 2018, to reflect new HMRC Guidance which confirmed that the new tax rules would apply to payments made on or after 6 April 2018 in circumstances where the employment is also ended on or after 6 April 2018.
All content on this page is correct as of March 22, 2018.