UK: Richardson v Delaney - Inland Revenue Approach Means Pay-Off Tax Concession Lives to See Another Day

Last Updated: 16 October 2001
The Inland Revenue has now clarified its treatment of the £30,000 tax exemption, following uncertainty caused by the case of Richardson (HM Inspector of Taxes) –v- Delaney ([2001] IRLR 663). Some commentators have interpreted the case as drastically reducing its availability, but the Revenue has now confirmed that its practice in this respect remains unchanged.

The issue
Where employer and employee reach an amicable parting of the ways, they sometimes agree to terminate the employment contract without implementing either party’s right to give notice (and without exercising any contractual right to make a payment in lieu of notice or "PILON"). Because termination results from agreement, there is no breach of contract, and no right to compensation for lack of notice. Instead, the employer makes a payment to induce the employee to give up his rights under the contract, including his right to receive notice. This allows the employee to leave without the stigma of dismissal, and leaves the employer with restrictive covenants intact (because it has not breached the contract) and no exposure to dismissal claims (because there is no dismissal which could be unfair or wrongful). The employee may also agree to waive any other claims he has as part of the agreement.

Existing Inland Revenue practice
A payment which has its source in the contract of employment is fully taxable as an "emolument" from the employment. Thus a payment exercising a contractual obligation or right to make a PILON (or pursuant to an expectation or custom that a PILON be made) is fully taxable. In contrast, where the source of the payment is an agreement reached as part of the termination process (and the payment is not settling a pre-existing contractual entitlement), the Inland Revenue had always allowed the £30,000 tax exemption to apply to the termination payment.

The £30,000 tax exemption is also applied to damages for breach of contract. Caselaw has also established that where an employer has a discretion under the contract whether to make a payment in lieu, it is open to the employer to choose not to exercise the discretion and to terminate without notice, thereby breaching the contract – in that case any pay-off subsequently agreed will be damages for breach (Cerberus Software Ltd v Rowley [2001] IRLR 160).

Facts in Delaney
Mr Delaney's contract could be terminated by 18 months' notice or a PILON, at the option of the employer. In fact, he was given notice and then placed on garden leave for a month only while a settlement package was negotiated. The package he received was broadly equivalent in value to the PILON he could have been paid (which would have been taxable in full).

The original finding was that the employer had breached the contract and therefore the payment represented damages for breach. On appeal it was held that there was no breach of contract and the compensation package was taxable in full.

Judgment in Delaney unclear
There were two possible interpretations of the Delaney judgment:

  1. all payments made as a result of an agreed termination are fully taxable – the £30,000 tax-free slice will only be available where the employer has first breached the contract by dismissing without notice and the subsequently negotiated sum is paid as damages for breach, or
  2. where there is a discretionary PILON clause, a sum paid on an agreed termination is likely to be treated as paid under that contractual PILON clause and therefore fully taxable, at least where the payment is essentially the same as that provided for by the PILON clause.
Some commentators have suggested that the first interpretation was the correct one. This would involve a change in Inland Revenue practice and would make the common practice of reaching an agreed termination, rather than dismissing, much less attractive.

The Inland Revenue's approach
The Inland Revenue's Personal Tax policy unit has now confirmed in correspondence that, in its view, the second, narrower interpretation of the case is correct and its existing practice regarding the £30,000 tax exemption remains unchanged.

With regard to Richardson-v-Delaney, the Revenue writes:

"In the absence of a payment in lieu of notice ("PILON") clause in the contractual arrangements (and assuming that no expectation to receive such a payment otherwise existed), the Revenue would not have argued that s19 ICTA 1988 applied in this case. The reason that s19 ICTA was argued was … that the package received by the employee was essentially the same as would have been paid had the employer formally exercised its discretion to make a PILON in lieu of notice. In the absence of a breach of contract in the events surrounding the termination, the reasonable inference was that the source of the payment lay in that provision, albeit in this case that the employer chose to instigate negotiations concerning the form and amount of payment."
The Revenue goes on to say that, following Cerberus v Rowley,:
" it can no longer be assumed (as was the case following Abrahams v Performing Rights Society [1995] IRLR 486) that such contractual arrangements entail an automatic assumption that the employer has chosen to make a payment under those contractual arrangements if notice is not given. The effect of Cerberus is then that whether the discretion has been exercised is a question of fact in each case. The Revenue will consider all the surrounding circumstances in making that decision, and the Richardson case is relevant in that context in that it indicates that where the package equates to what would have been paid by exercise of discretion, there will be a strong presumption that the source of the payment lies in the same place. Hence, following EMI Group Electronics v Caldicott (71 TC 455), such a package falls within s19 ICTA 1988.

Where there are no contractual arrangements (and no expectation of a PILON on termination), the Revenue’s approach remains unaltered. That is, provided that there is no prior agreement, arrangement (or expectation) which may place the payment within the employer-employee relationship (as opposed to its termination), the appropriate section of charge will usually be s148 ICTA 1988."

Of course, the above is a statement of general policy only and each case will obviously be judged according to its individual factual circumstances.

Thus, where there is no contractual PILON clause (nor any expectation of such a payment), payments made on an agreed termination can still be paid tax free up to £30,000 (regardless of the fact that there is no breach of contract).

Where there is a PILON clause, a sum paid on an agreed termination is likely to be treated as paid under that contractual PILON clause and be fully taxable – the tax exemption will only be available if the PILON provision is discretionary and the employer can show that he has chosen not to exercise that discretion; this will most easily be established if the employer can show that the employee was in fact dismissed without notice and the payment is damages for breach of contract. In contrast, if the payment equates to what would have been paid by exercise of the discretion, there will be a strong presumption that the discretion was in reality exercised.

© Herbert Smith 2002

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

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