Last reviewed 28 March 2018

From 6 April some important changes to employment termination payments will come into force, which will affect employers who use payments in lieu of notice (PILONs).

What is a payment in lieu of notice (PILON)?

At present and provided the contract of employment allows for it, a PILON can be made by the employer upon termination of employment by either party.

There would be no subsequent risk of a breach of contract claim because there is an express contractual right for the employer to make a PILON payment.

PILONs are commonly used for staff working in sales, where an employee enters into a settlement agreement or where an employee is made redundant. They are used to allow employers to honour their obligation to pay for the requisite period of notice without the need for the employee being present for all or part of the notice period.

What’s changing?

Occasionally, where a PILON is made but the employer does not have an express contractual right to make such a payment, that payment can receive up to £30,000 income tax exemption. This tax exemption has attracted discontent from HMRC and there have even been examples where employers have taken a deliberate decision to exclude a contractual PILON clause in an effort to take advantage of this favourable treatment towards taxation.

Consequently, with effect from 6 April 2018, the Finance (No. 2) Act 2017 provides that all PILONs representing “basic pay” will be subject to tax and National Insurance Contributions (NICs) regardless of whether or not there is a relevant PILON clause in the contract of employment.

Why has the PILON legislation changed?

The new legislation serves to clarify and tighten rules on the taxation of termination payments. Employees will now be required to pay income tax and Class 1 NICs on the contractual payments that they would have received had they been required to work their notice in full even where there was no existing contractual provision allowing their employer to make a payment in lieu. The distinction for tax purposes between contractual and non-contractual payments is therefore being removed.

The first £30,000 of a termination payment will however remain exempt from income tax. Although employers’ NICs are due to be imposed on termination payments which are in excess of the £30,000 tax-free amount, this will only apply to termination payments made on or after 6 April 2019.

These measures are being introduced to minimise the incentive for employers to manipulate the rules by structuring arrangements to include payments that are ordinarily taxable in order to minimise the income tax and NICs due. It serves to standardise the taxation of termination payments by clarifying that all PILONs are subject to tax and NICs.

What do the changes mean for businesses?

As a consequence of these changes, there is likely to be a marked increase in the number of employers who include PILON clauses in their contracts henceforward.

In addition, many employers may need to consider factoring in additional payments to reflect the added tax and NIC payments that employees will incur particularly where they are seeking settlement agreements.

One advantage of having contractual PILONs is that they will remove the previous unintended consequence of non-contractual PILON payments whereby the employer was subsequently unable to rely on any restrictive covenants because, by making a payment in lieu, they were technically considered to have breached the employee’s contract of employment thus rendering the other elements of the contract unenforceable.

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