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Termination payments – when the PILON falls down

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It is now a year since HMRC changed the rules relating to the taxation of termination payments made by employers to employees, normally done through a settlement agreement. While the first £30,000 of a non-contractual termination payment remains payable without deductions for income tax or National Insurance (NI) contributions, last April HMRC set out new provisions to prevent employers and employees from ‘hiding’ notice pay within the tax free element of the severance payment.

We are frequently instructed to advise employees on settlement agreements and despite the changes to the law that came into effect last April, we continue to find employees who are told they will be getting a single lump sum payment tax free. If they are not working their notice period and if there is no separate provision for a payment in lieu of notice (PILON) to be taxed, then the employee might be left facing a nasty shock when HMRC scrutinises the severance payment at a later date.

Why is this a problem for the employee rather than the employer, you may ask?

The reason lies in the fact that nearly every settlement agreement contains a clause stating that the employee will be liable to reimburse the employer for any tax that HMRC deems to be payable on the termination payment. Such clauses may also require the employee to be liable to the employer for any interest or penalties that are imposed on it by HMRC. Rarely will an employer agree to vary this standard wording in the settlement agreement, so it is all the more important that an employee receives good advice on the how the payment has been structured.

Take the example of Louise who earns £45,000 a year and whose contract states she is entitled to 3 months’ notice. If her employer offers her a severance package of £22,500, amounting to 6 months’ gross pay, but fails to take account of her notice entitlement, Louise will run the risk that one half of the severance payment (£11,250) will be deemed taxable by HMRC, as it is the sum that equates to Louise’s contractual notice pay.

We often find that when we raise this issue with employees, they are surprised to learn that what their employer told them is not accurate. “But they sent me an email saying they would pay me the money tax free” is a line we hear; yet what is in the email will be overridden by what is in the settlement agreement, including the tax indemnity clause in the employer’s favour which will almost certainly be contained in the settlement agreement.

Before they make a decision, employees should therefore be careful to make sure the settlement offer being made to them by their employer is really as attractive as it might first appear.

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