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United Kingdom

Many employers have incorporated a pay in lieu of notice clause (PILON) into their contracts of employment. This clause reserves the right of the company to terminate an employment with immediate effect by making a payment in lieu of that person's entitlement to notice. (The legal advantage of the clause is that termination can occur with immediate effect but without any breach of contract. This means any post-termination obligations on the employee, such as restrictive covenants, may remain in force rather than fall away due to the employer's breach.)

The Inland Revenue has taken the view that any payment made under such a clause is subject to income tax withholding (and National Insurance) in full rather than falling within the tax relief up to £30,000 ($43,400) applicable to termination payments. Also, some people have argued that a PILON clause means the employer must pay the payment in lieu in full if it does not give notice.

The Court of Appeal decision in Cerberus Software Ltd v Rowley (2001) has caused both of these propositions to be reviewed. Here, the contract reserved the right to pay in lieu. Mr Rowley was summarily dismissed on grounds of misconduct that were held at tribunal to be unfounded. He claimed his full six months' notice under the PILON. The court interpreted the clause as giving the right, but not the obligation, to pay in lieu. The employer had chosen not to exercise that right and had instead acted in breach of contract. The employee was not entitled to the full PILON sum. Ordinary damages principles applied and his award was reduced to take into account his earnings since then in mitigation of his loss.

This raised the possibility that a termination payment may be exempt from tax, up to the first £30,000, despite the existence of a PILON, if payment was damages for breach rather than an exercise of the PILON.

If this sounded like good news for the taxpayer, Richardson (HM Inspector of Taxes) v Delaney appeared not to be. In that case, a PILON clause was also not implemented upon termination. The employee was given notice and commenced his notice period on garden leave. Negotiations ensued for the employment to end prior to the expiry of the notice period on payment of an agreed sum. This roughly equated to the remainder of his notice pay.

The High Court decided that the payment should be assessable to tax in full. This negotiated settlement amount, which closely equated to the pay for the balance of the notice period, should not escape tax. There was no evidence of a breach of contract.

The Inland Revenue has now commented on the Cerberus case. It recognizes that a PILON clause may merely give the employer a discretion to pay in lieu, which it is free to exercise, or not. So, it recognizes the possibility of the employer not exercising the PILON and in those circumstances indicates that it may allow the beneficial tax treatment.

It will, however, look very carefully at the facts to decide whether the employer has actually exercised that discretion or has decided not to do so and instead to terminate in breach of contract. Only when termination is clearly in breach of contract will the beneficial tax (and National Insurance treatment) be available.

The Revenue, in its comments, pointed to Delaney as an example of where the facts demonstrated that a PILON had in fact been exercised (as the High Court decided).

So, where there is an express PILON clause, it appears there must at least be a clear breach of contract and probably a payment which does not equate to the PILON amount if there is to be any hope of securing the favourable tax treatment.

Employers should not assume, however, that if there is no contractual PILON clause the tax and National Insurance relief will be available. The Revenue's view is that a payment made in lieu of notice where an employee has an expectation of receiving such a sum will also be fully taxable.

In addition, there was a suggestion in the judgement in Delaney that any negotiated severance payment would be taxable, PILON or no PILON, expectation or no expectation. Some commentators have said this means the £30,000 exception is only available if there is a clear breach of contract. This would mean terminate first, negotiate later – hardly a preferred human resources option, and where would it leave redundancy programmes? The Revenue's comments on Cerberus mention Delaney but do not indicate they will take this aggressive line. However, the position is unclear and nobody can proceed with certainty at this stage.

Nevertheless, employers should take care over the structure of severance arrangements and how payments are documented. This is particularly the case where the payment is high and there are substantial employer's National Insurance savings to be made.

Darryl Evans and Marian Fertleman

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