Is a payment in lieu of notice (PILON) tax free?

In some circumstances, yes, but this may be about to change.

Contracts of employment will often include a clause, which provides that employers can terminate the employment immediately by making a PILON, rather than having to give the full period of notice. The principle reason for this is to ensure that any restrictive covenants remain enforceable. In addition, such a payment can be used to limit it to basic salary only and it can be used to exclude any bonus or share options, which would have otherwise vested during the notice period.

A PILON made in these circumstances is taxable and liable to NICs.

Where there is no contractual PILON, then it can be paid without deduction of tax and NICs subject to a cap of £30,000.

The position becomes unclear in the following situations:

  • Where there is a contractual PILON clause in the contract but the employee waives the right to notice or there is a mutual agreement to terminate early, HRMC will usually still seek to tax a portion of any severance payment equivalent to the earnings of the notice period.
  • If the employee claims constructive dismissal, it is arguable whether the payment is damages for breach of contract or a payment under a PILON clause. In theory, if the employee resigns and the employer is in fundamental breach of contract, it is no longer able to rely on any term of contract including PILON clauses and so HMRC should not be able to successfully argue that the payment is made under the PILON clause.

Many employers have the custom of making PILON payments, in the absence of a contractual PILON clause. In these circumstances, HMRC may seek to tax a such a payment on the basis that an implied contractual right has arisen. This will occur where the making of a PILON could be said to be an automatic response to a termination.

This current position regarding the tax treatment of these payments is about to change.

The HRMC has published a response document together with draft legislation confirming that, from April 2018, the distinction between contractual and non-contractual PILONs would be removed so that all such payments will be treated as earnings subject to income tax and employer NICs.

It is proposed that all payments that an employee receives or would have received during their notice period will be taxable as general earnings.

Whilst this is only draft legislation, it is likely that, from April 2018, the position regarding the tax treatment of PILON will change.

Watch this space for further developments.

If you have any questions regarding this article, then please contact Sejal Raja on sejal.raja@rlb-law.com.

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