In this month's Tax Bulletin, the Inland Revenue has produced new guidance for the tax treatment of payments in lieu of notice (PILONs).
The issue arises where a contract of employment contains a right (but not obligation) for the employer to make a payment in lieu of notice. If that right is exercised, then any payment to the employee is regarded as an emolument from employment and is therefore taxable in full.
By contrast, if the employer does not terminate using the PILON clause, but instead chooses to breach the contract, then four consequences follow:
1. the payment is regarded as damages for breach of contract, and as a 'termination payment' by the Revenue. It therefore falls into the £30,000 tax-free category;
2. class 1 national insurance contributions are also not payable (which saves money for both employee and employer);
3. the employee is under a duty to mitigate his/her losses, and must give credit for any earnings received during the notice period;
4. the employer (probably) loses the right to rely on restrictive covenants within the contract.
In summary, the Revenue's position is:
• a settlement that is substantially the same value as any payment that would have been made under the PILON clause is likely to be viewed as being made under the PILON clause - therefore fully taxable.
• in other words, in the absence of any identifiable breach of contract, the Revenue will assume that the payment has been made lawfully, even if it is not precisely the same amount as provided for by the contract;
• the Revenue may often accept that the payment has been made as damages for breach if, for example, the payment was reduced to reflect mitigation of loss, an adjustment has been made to reflect tax and NI consequences, or the decision not to exercise the PILON clause is evidenced in writing.
The Tax Bulletin makes it clear that incomplete documentation is usually the trigger for the Revenue assuming the payments are taxable. The moral is clear - documentation must be plainly drawn up at the time of the payment showing the payment is being made in breach of contract rather than pursuant to a PILON clause. Plainly, few employers will want to do this if there are restrictive covenants which it wishes to remain in force.