Taxing termination payments – a knotty issue

Posted by RM2 at 12:14 on 27 Oct 2015


While not directly related to employee share schemes, this is a question that arises for many small businesses. A recent case, and a response from the Law Society to a government consultation on this issue, provide a good example of why it is a question not always easily answered.

Mr A was made redundant, signed a Compromise Agreement and received a termination payment accordingly. His lawyers argued that the first £30,000 of the payment should be free of tax and NICS because it was a redundancy payment; Mr A’s ex-employer disagreed and sought to tax the whole amount under PAYE. For various reasons, Mr A did not pursue this point at the time of the payment but instead sought to recover what he saw as the overpaid tax when he submitted his tax return.

HMRC disagreed with Mr A. While it seemed that Mr A had indeed been made redundant, they needed to look at the reasons for the actual payment that was made. Mr A’s employment contract allowed the Company discretion as to whether it would pay employees in lieu of notice; the Compromise Agreement made it clear that the payment made to Mr A was indeed made in lieu of notice. Therefore, the payment was made under that contractual “PILON” clause and arose as an “emolument of employment”. The £30,000 exemption did not apply.

All too often it is automatically assumed that when an employment is terminated then £30,000 of the termination payment will be free of tax. This is not the case, and in many situations the outcome is down to the inclusion or otherwise in the employment contract of a PILON clause. The Law Society’s response to the government’s consultation on the taxation of termination payments sets the issue out quite plainly:

“The current situation is that if an employer exercises its right to terminate employment by way of a PILON, the relevant payment is taxable if the employee’s contract contains a PILON clause. If there is no PILON clause, then, even if the employee does receive a payment which is an equivalent of a payment in lieu of notice, the payment is not taxable if the payment can properly be characterised as damages for termination of employment. The consequence of this is that employees with contracts including PILON clauses are treated less favourably in tax terms than those with PILON clauses in their contracts.”

In particular, the Law Society notes, whether or not a PILON clause is included is nothing to do with obtaining a tax advantage on termination. Rather “PILON clauses are included … in order to enable the employer to terminate employment without notice but without a breach of contract, thereby retaining the benefit of any post-termination restrictive covenants in the employee’s contract. The differential tax treatment is an unintended consequence.”

The Law Society suggests that the distinction between contractual and non-contractual PILONs should be removed. Doubtless Mr A would agree.

There is a link to the Law Society’s Response to HMRC here.