A taxing time for PILONs

As of April 2018, amendments will be introduced to Part 6, Chapter 3 of the Income Tax (Earnings and Pensions) Act 2003 (‘ITEPA’), which deals with the taxation of termination payments in employment. A key change is to be made to the taxation of payments in lieu of notice (PILONs). Helen Wyatt looks as the new legislation in this KeyNote.

What is the problem with taxation of PILONs?

At present, the tax treatment of PILONs is somewhat complicated and arguably unfair. The tax position differs depending on whether the PILON is considered to be contractual or non-contractual.

1. If the employer’s ability to make a PILON is a contractual right and it exercises that right in accordance with the contract, then the PILON is taxable as earnings and subject to deduction of PAYE income tax and NICs at source.
2. If the contract of employment does not give the employer the right to make a PILON, then the making of a PILON is technically a breach of contract and the payment should be classified as damages for breach of contract and the first £30,000 of the payment will not be taxable unless the employer habitually makes PILONs as an automatic response to termination.
3. If the contract of employment contains a discretionary PILON clause, meaning that the employer can choose to make such a payment or not, then whether such a payment is taxable or not depends on the facts of the case and whether, in the circumstances, the contractual right has been exercised or whether the parties have agreed an alternative position which equates to a damages payment for breach of contract.

Clearly the fact that some PILONs are fully taxable, some are not and there is some uncertainty from case to case as to which are and which are not, is an oddity. Historically, employers may have consciously chosen not to include a PILON clause in their contracts of employment in order to be able to use a tax-free PILON as a bargaining tool as part of an exit negotiation.

As from April, this option will no longer be available.

So what is the solution?

All PILONs whether contractual or not will be taxable earnings.

According to the Government’s policy paper entitled “Income Tax and National Insurance contributions: treatment of termination payments”, a termination payment will be capable of having two elements: a part that benefits from the £30,000 tax-free exemption and a part that does not. Employers will need to identify any portion that should be treated as employment income and deduct tax accordingly. A part that equates to a PILON or a partial PILON will fall into the taxable category, whether it is a contractual payment or not and regardless of the labelling or categorisation that the employer may attempt to apply to it.

While the policy paper makes it sound very simple, the amendments to ITEPA appearing at sections 402A to 402E to give effect to the policy are not. The legislation is necessarily complicated in order to give certainty as to what portion of a termination payment, if any, is referable to a “post-employment notice period”. If there is such a payment, the legislation also defines a calculation for the amount of “basic pay” that is referable to that period. It goes into detail as to what kinds of payments would not constitute basic pay for these purposes and are therefore not “post-employment notice pay” and consequently not taxable under section 402 of ITEPA (although such payments may be taxable under other provisions of the Act).

While the legislation is complicated, the concept is sensible, and one would expect the calculation to be easier to grasp in practice, if not on paper.

For further information on this or any other employment law matter, please contact Helen Wyatt or any other member of the Keystone Employment or Tax teams.