We’ve all been there – after weeks of wrangling over the commercial terms of a departure package particularly in a settlement agreement, everything is committed to paper and suddenly it becomes apparent that the negotiating parties’ understanding of how various termination payments will be taxed is rather different.

The issue is often particularly thorny in relation to payments in lieu of notice (PILON) and whether they should be taxed at all. For contractual PILONs (often set out in a written contract of employment), the situation has always been clear – they should be subject to deductions as a normal earnings payment. For non-contractual PILONs, things are much greyer – is it a so-called ‘auto PILON’; is there a custom and practice of always making a PILON despite no written contractual right to do so (therefore making it vulnerable to being considered as a contractual PILON); is it a damages payment for breach of contract?

In an attempt to clarify things, the government has recently consulted on how to simplify the payment of tax and NICs on payments made at termination of employment.

The key outcomes of the consultation are as follows:

  • all PILONs, whether contractual or non-contractual, will be subject to the deduction of income tax and NICs;
  • the tax free limit on termination payments will remain at £30,000 and will, in principle, remain available for all forms of compensation;
  • compensation above £30,000 will be subject to deductions for income tax and employer’s NICs (previously they were exempt from all NIC deductions); and
  • injury to feelings payments will be expressly excluded from the exemption for injury payments, unless there is a medically recognised psychiatric injury.

Those changes are all due to take effect from April 2018 and comments have been invited on the draft legislation by early October.

It is the change to the taxation of PILONs that is likely to prove most problematic. The consultation responses largely agreed that the current differing tax treatment is complex and leads to incorrect deductions being made and potential unfairness. There was also some agreement with the government’s view that payments can currently be manipulated to secure favourable tax treatment.

The new proposals are intended to ensure that any post-employment payment that covers part of an existing contractual entitlement (including the notice period even if an employee does not work it) will be subject to deductions as earnings. It is therefore anticipated that the ability to treat any notice payment as tax free will be very limited and that HMRC will be vigilant of any attempt to describe such payments as non-taxable damages payments.

In practice, we increasingly see PILON clauses included as standard in employment contracts so the impact of the change may be more limited than it would have been some years ago. However, the changes overall are still likely to have an effect on the net amount an employee receives and it therefore has implications for both parties in a departure negotiation. This can be a complex area and we would always advise that professional legal and financial advice is taken.

Our employment solicitors work in partnership with organisations to improve their HR practices and advise on employment issues. To discuss this article or any other HR issue call 01392 210700 or employment@stephens-scown.co.uk.