The Inland Revenue is challenging the tax-free status of Payments in Lieu of Notice (PILONs), arguing that even where there is no PILON clause in an employment contract, these payments stem from the employment and, as a result, should be subject to income tax and NIC. Lesley Sadler takes a closer look.

It has been accepted for some time that a discretionary clause within a contract of employment, allowing an employer to make a PILON, makes any payment made on termination of the employment taxable and liable to NIC in full. Similarly, the common belief has been that a PILON not allowed for in the contract of employment may be paid free of tax and NIC. However, on this second point, the Inland Revenue seems increasingly likely to disagree, causing considerable problems for employers in the process.

From the employment, or from the termination?

By way of background, if an employee receives a payment, including a PILON "in connection with" or "from" the employment, then the payment represents general earnings and as such will be taxable in full. The payment will also represent earnings for NIC purposes. In contrast, if an employee receives a payment in connection with the termination of the employment, then the payment is taxed by reference to the specific legislation relating to termination payments. As such, the first £30,000 of the payment will be tax free. (Other exemptions and reliefs may also apply, e.g. for Foreign Service), similarly, no NIC will be payable.

Clause allowing a PILON payment to be made

The decision in the tax case of EMI plc v Coldicott established that where there is discretion in a contract or staff handbook to make a PILON and this is paid, then it is taxable and liable to NIC.

Following the employment law case of Cerberus v Rowley, however, it is also open to the employer to ignore this right to make a PILON and simply act in breach of the contract. If the employer chooses to act in this way, then any payment made as a result of the breach will represent damages. As damages, the payment should qualify for the £30,000 tax exemption and be free from NIC. (This point is discussed in more detail below).

So, where there is a PILON clause, it does not necessarily follow that any payment made to the employee because he is not allowed to work the notice period is taxable and liable to NIC in full. It is a question of fact as to whether the payment is damages or a contractual PILON.

It is worth bearing in mind, however, that there may be good employment law reasons why a PILON clause has been used. This is because the presence of such a clause means that the contract may properly be terminated by paying a PILON without the employer being in breach of contract. It may be important that the employee continues to be bound by restrictive covenants contained in his contract of employment. These clauses would cease to apply if the contract were breached.

Damages are not earnings

A payment of damages compensates the employee for a wrong that he has suffered. For example, if there is no clause in the employee’s contract allowing for a PILON payment to be made and the employer terminates the contract without giving notice, the employer has breached the terms of the employment contract. Until the Inland Revenue’s view changed, it was believed that any PILON payment compensating the employee for this breach would represent damages.

The payment of damages relates to the breach of contract, not to the employment. As a result, a payment of damages does not represent general earnings for tax purposes nor earnings for NIC purposes. As a result, no NIC would be payable and the £30,000 tax exemption would apply.

Inland Revenue view

The Inland Revenue, however, maintains that a non-contractual PILON can still be taxable as general earnings. This view is based on the notion that earnings from an employment can extend beyond what is provided for in the contract of employment or implied by the employer. The Inland Revenue maintains that a PILON can still be from the employment even where the employer appears to act in breach of the terms of the employment contract.

The Inland Revenue justifies its approach by saying that where the payment of a non-contractual PILON is an "automatic response" to a particular situation, e.g. redundancy, then the payment does not bear the characteristics of damages. If the Inland Revenue is correct and the PILON payment does not represent damages, this means that the payment will be earnings from the employment and liable to tax and NIC in full.

The Inland Revenue’s stated view is only that the PILON could, in such circumstances, be something other than damages. The difficulty is that the Inland Revenue seems to expect employers to provide evidence that the payment is actually damages before it will accept it as such. In other words, the Inland Revenue starts from the point that the payment is made from the employment. This is an odd position to take. It is difficult to understand that any compensatory payment intended to avoid a claim for damages by the employee (for not being allowed to work his notice period) can be said to be unrelated to damages and simply part of the employment terms.

How do you distinguish between damages and a PILON?

In order to apply the correct tax treatment, employers must distinguish between PILONs that are liable to tax and NIC in full and those that qualify for the £30,000 exemption and are NIC free. As discussed above, there are two scenarios where this isrelevant:

  • The first is where there is discretion in the contract to pay a PILON, but it is a question of fact as to whether or not the employer has terminated the contract in accordance with this term and whether or not the payment made to the employee represents damages.
  • The second is where there is no discretion allowing a PILON to be paid, but the payment may be viewed as an "automatic response" by the Inland Revenue and not as damages.

Looking at each of these scenarios in turn:

  • Discretion to pay a PILON, but possible payment of damages?

In order for a payment to be recognised as damages, it would be necessary to demonstrate that the contract had not been terminated in accordance with the PILON clause. (In the absence of any evidence to the contrary, the inference must be that a PILON has been paid in accordance with the contract). It would therefore be necessary to document the decision-making process and provide this to the Inland Revenue, if appropriate.

It is also worth bearing in mind that the payment of damages is subject to the principle of "mitigation". In this way, the Inland Revenue would certainly expect that the amount of any damages would be less than the amount payable in accordance with the PILON clause, as account would have to be taken of mitigation.
  • No PILON clause, but is the payment an "automatic response"?

The guidance the Inland Revenue issues to its staff makes clear that, where there is no discretionary clause allowing a PILON to be made, an employer can choose to pay more to an employee than strict legal entitlement, without altering the fact that the payment is still damages. It remains to be seen as to whether the Inland Revenue will continue to adopt this position.

The issue, however, of what is an automatic response is a difficult one. Inland Revenue internal guidance also states that where an employer intends to follow a particular course of action, this can quickly become a custom or an automatic response. It is clear that where an employer has had a number of redundancy programmes and has always made a payment upon termination of employment contracts, then the Inland Revenue will be looking at the facts very closely in order to try to argue that these payments stem from the employment and are PILONS, not damages.

In order to avoid any claims that PILON payments are automatic, employers will have to demonstrate that they have considered each case individually and determined what will be paid and why.

The decision-making process must be properly documented so that evidence can be provided to the Inland Revenue, if requested.

Conclusion

At present, it is not entirely clear what the Inland Revenue means by automatic response. However, where there is no PILON clause in the employment contract, it is becoming increasingly common for the Inland Revenue as part of Employer Compliance Reviews, to challenge PILON payments, both in redundancy and other situations. In view of the number of redundancy programmes over the past few years, this will affect a large number of employers. Employers who have made payments could find themselves faced with demands for substantial tax and NIC liabilities.

As indicated above, the view of the Inland Revenue is not one we agree with. So far robust defence has proved successful in refuting claims, however the attitude of the Inland Revenue is unlikely to change until this point is debated fully in the courts.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.