Most employers will, at some stage or another, have parted company with an employee by way of entering into a settlement agreement. Under such an agreement an employee is usually paid a sum of money in return for waiving any potential claims he or she may have against the company.
When advising employers and employees on settlement agreements we are often asked to advise on the tax treatment of the termination payment, with the basic position being that any payment of £30,000 or below, which is non-contractual and paid in connection with the termination of the employee’s employment, is made free of tax.
However, there is often some confusion surrounding the tax treatment of a payment in lieu of notice (“PILON”) and whether this can be included as part of the tax free amount, or whether tax and national insurance are properly payable on it.
The current position
The general position currently is that if an employee’s contract of employment allows for a PILON to be made as an alternative to serving notice, then the payment must be made subject to tax and national insurance. In that situation, the payment is contractual rather than a payment connected to the termination of employment. It should therefore be dealt with separately to any tax free payment within a settlement agreement.
Where the contract of employment doesn’t contain a PILON clause, but the employer wants to terminate immediately and pay in lieu, employers (up to now) have been able to make such a payment tax free. This is because, in the absence of a PILON clause, terminating without notice technically amounts to a breach of contract and the accompanying payment is classed as damages. The ability to do this was often a sweetener to an exit package, which often assisted the parties in reaching a settlement.
Changes from April 2018
From 6th April 2018, it will no longer be permissible to make any PILONs free of tax, with the government opting to tax as earnings the basic pay an employee would have earned had they worked their notice period in full. This will be the case regardless of whether the employment contract contains a PILON clause.
Where an employee receives a PILON, it will always be subject to tax, no matter how much of the notice period is paid in lieu. For example, if the employee is on a three month notice period, they work one of these three months and are paid in lieu for the remainder, they will of course pay tax and national insurance on the notice worked, but they will also pay tax on the two month period paid in lieu.
The £30,000 tax free exemption will still remain, but only in relation to payments on termination that are in no way referable to the notice period or employment contract.
Tax indemnities
An issue we often experience is that, whether or not an employer is entitled to make a PILON free of tax, they will make the payment tax free under a settlement agreement and seek a tax indemnity from the employee to cover the risk should HMRC pursue it years down the line. Sometimes an employee will take that risk. However, such indemnities are much less likely to be agreed to in future if the settlement agreement does not set out the correct tax position.
Employer national insurance contributions
An additional change from April 2019 will be the requirement for employers to pay national insurance contributions on any portion of a termination payment over £30,000. Currently there is no such requirement. This measure was due to come into force in April 2018, but has subsequently been delayed.
Michael Shutt
Solicitor, Employment at Berry Smith Lawyers
Please contact us if you would like more information about the issues raised in this article or any other aspect of employment law at 029 2034 5511 or employment@berrysmith.com