Article by Nick Treppass and Andrea Nicholls

Originally published by People Management - 17 April 2003

How can employers use compromise agreements and make payments in lieu of notice without falling foul of the taxman? Nick Treppass and Andrea Nicholls explain

Reports that up to 30,000 more City jobs were in danger if the Iraq war dragged on into the summer have brought compromise agreements and termination payments to the top of the HR agenda. Compromise agreements are commonly used to guard against unfair dismissal and discrimination claims, yet there is still widespread uncertainty about their provisions and tax implications.

The Inland Revenue recently published new guidance on the treatment of payment in lieu of notice clauses (Pilons) (February 2003 Inland Revenue Tax bulletin) which has helped clarify the position.

Pilons are made where an employee gives notice, or as in a redundancy, is given notice but is not required to work out the notice period. Instead, the employee receives a lump sum covering wages and other contractual entitlements for that period.

This sum is subject to normal taxation if the employment contract contains a right (but not an obligation) for the employer to make a Pilon. If the employment contract does not include a Pilon clause, the termination payment will be tax-free up to £30,000. Above that, the employer must deduct tax.

The Inland Revenue's bulletin points out that if an employer chooses to terminate a contract without using the Pilon clause and makes a settlement worth substantially the same as any payment that would have been made under such a clause, then it may be regarded as a contractual Pilon and therefore would be fully taxable.

An employer who chooses to breach a contract in this way will normally lose the right to rely on post-termination restraints, while the employee may lose out financially as the Inland Revenue may regard the payment as taxable. The lesson here is clear: if a payment is made in breach of contract, and not as a Pilon, the documentation needs to make this clear - ideally by referring to a payment of damages for the breach of contract.

Another important consideration is when to issue a P45. Delaying the termination payment until after the P45 has been issued can have a significant cashflow benefit for the higher rate tax-paying employee, because tax should be deducted at the basic, rather than higher rate.

So should employers include a Pilon clause in contracts of employment? This will depend on a number of factors. If there is a need for post-termination restraints, it may be advisable to include such a clause because an employer who makes a Pilon without having a contractual right to do so is in breach of contract, and any post termination restraints may become invalid. If these restraints are not required, it may be better not to include a Pilon clause as this may help the employer and employee take advantage of the £30,000 tax-free exemption.

What factors should HR professionals consider when deciding whether or not to use a compromise agreement?

The first is the likelihood of the employee bringing a claim. If the employer has acted correctly throughout and the dismissal is relatively straightforward, arising - for example, from an obvious redundancy situation - a compromise agreement may not be necessary. If, however, it is likely that a dissatisfied employee will bring about a claim, any settlement should be made via a compromise agreement.

The second factor to consider is the size of any payment. If the payment is in excess of the employee's statutory or contractual entitlement, it should always be made via a compromise agreement to avoid any possibility of a claim.

Finally, a compromise agreement should refer to a settlement of a particular complaint or proceedings - for example, unfair dismissal or sex discrimination - and not to the general "full and final settlement" of all claims usually used in settlements negotiated through Acas. The employer must also ensure that the employee gets independent legal advice.

Nick Treppass and Andrea Nicholls are partners in the employment department of the law firm Howard Kennedy.

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