Either an employer or an employee can notify the other of termination of employment by giving notice. Once given, the employee will usually work a period of notice in accordance with their employment contract, and be paid accordingly.
However, in some instances, the employer will make a payment in lieu of notice (PILON) to the employee instead of them working their notice period. If exercised, it would allow that employee to leave their job immediately and be paid a sum equivalent to their notice period.
According to new tax laws coming into force from 6 April 2018, all payments made to employees in respect of notice payments (including damages for breach of contract) will be taxable.
Background – Pay in Lieu of Notice
PILONs may be split into four categories:
- Contractual PILON – made by reference to a clause in the employment contract;
- Automatic PILON – made as an employer’s automatic response to notice being given;
- Discretionary PILON – made at an employer’s discretion; and
- Compensatory PILON – made as damages for loss of notice.
Under current tax laws, PILONs falling within the first three categories (Contractual, Automatic and Discretionary) are subject to income tax and national insurance contributions, as if the employee was paid for working during their notice period. This is because the amount of these PILONs is determined by an employee’s entitlement under their employment contract had they worked their notice period.
In respect of the fourth category, Compensatory PILONs, any payments of up to £30,000 made to the employee may be tax exempt if such payment is regarded as “damages for breach of contract”.
It is important to note that any payments made to an employee are subject to heavy scrutiny by HMRC and ultimately it is up to HMRC to decide what sums are taxable or not.
Reform of Tax and NICs on all payments in Lieu of Notice
From 6 April 2018, all PILONs will be taxable.
The provisions for Contractual, Automatic and Discretionary PILONs remain in place. These will be subject to income tax and national insurance contributions. However, the tax rules relating to Compensatory PILONs are changing.
Where a Compensatory PILON is made, there are complex formulae set by the government to determine exactly how much of that payment should be taxable. This taxable sum is referred to as “post employment notice pay” (PENP).
The intention is to tax (and subject to Class 1 NICS) as earnings the basic pay an employee would have earned had the employee worked his or her notice in full.
The calculation of PENP differs depending on number of factors. There is a formula for employees that are paid monthly, whose contractual notice period is expressed in months and whose employment is terminated with immediate effect or whose unworked periods of notice is a whole number of months. A more complicated formula is applied if the employee is not paid monthly or the employee’s notice period or unworked period of notice is not expressed in months.
Consideration will need to be given in particular to the wording in Settlement Agreements on this going forward to show tax treatment.
Looking ahead – April 2019
As of April 2019, the employer must pay national insurance contributions as well as tax on termination payments above £30,000. The employee’s national insurance exemption will continue to apply.
Both employers making, and employee taking, relevant termination payments should be aware of the imminent changes regarding taxation as the new laws will have significant tax liability implications for both parties. For a summary on the upcoming changes, please refer to the HMRC website: https://www.gov.uk/government/publications/income-tax-and-national-insurance-contributions-treatment-of-termination-payments/.