A recent High Court case has reaffirmed that the taxable status of a payment in lieu of notice (PILON) depends on the wording of the employment contract.

The treatment of a PILON for income tax and national insurance contributions (NIC) purposes depends on whether it is:

• earnings from employment - in which case it is subject to income tax and NIC in full; or
• compensation for the termination of the employment - in which case the first £30,000 is exempt from tax and NIC.

In determining the tax position, the traditional approach was to look at the employment contract. A PILON was taxable as earnings if it was made pursuant to a right or discretion in the contract (for example, a clause allowing the employer to terminate the contract by giving either three months’ notice or making a payment in lieu). In contrast, a PILON made in circumstances where the employment contract did not contain a PILON clause was taxed as damages for breach of contract (i.e. the failure to give notice), thereby qualifying for the £30,000 exemption.

HMRC practice

A few years ago, however, Her Majesty’s Revenue & Customs (HMRC) started seeking to extend the situation in which a PILON could be taxed as earnings.

In its February 2003 Tax Bulletin, HMRC asserted that where a PILON was paid as an ‘automatic’ response to the termination of employment, it would be taxable as earnings - even if the employment contract did not contain a PILON clause. HMRC indicated that where the amount of the PILON was equal to the employee’s gross salary for the unworked notice period, it was likely to be taxed as earnings. This was on the basis that a ‘true’ damages payment would be reduced to take into account mitigating factors, such as the possibility that the employee might find another job before the end of his or her notice period.

The SCA Packaging case

The latest High Court case on this issue, SCA Packaging v HM Customs & Excise (22.2.07, unreported), suggests a return to the basic question of whether the PILON was made pursuant to a clause in the employment contract in deciding the appropriate tax treatment.

The case involved a company making several employees redundant over a five-year period. There was no PILON clause in their employment contracts. However, the collective agreement between the company and the relevant trade unions set out terms for redundancy pay. These included an ex gratia redundancy payment and payment for ‘any unexpired period of notice as at the date of termination’.

After discussions with trade unions, the company offered PILONs to those employees who were made redundant. Employees who rejected the offer were permitted to work their notice periods.
HMRC argued that the PILONs paid to non-office staff were taxable as earnings from the employment. The basis for this was that the collective agreements gave the employer a contractual right to terminate the contract before the end of the notice period and, if the employer exercised that right, the employee had a contractual right to receive a PILON.

The Special Commissioner found that the collective agreement was incorporated into the employment contracts but it did not give the employees a contractual right to receive PILONs. Rather, the PILONs derived from the subsequent agreement between the company and the employees as to which period of notice should be worked. This subsequent agreement varied the terms of the original employment contract. The PILONs were therefore part of the employees’ employment contract and taxable as earnings.

The High Court agreed that the PILONs were taxable as earnings but for different reasons. It found that there was no variation of the employment contracts. Irrespective of whether the company paid the PILONs unilaterally or with the employees’ agreement, they were made pursuant to the provisions of the employment contracts, which incorporated the terms of the collective agreement.

A setback for HMRC’s interpretation?

The Special Commissioner had considered an additional issue related to office staff. He found that the collective agreement had not been incorporated into their employment contracts, so they had no right to receive a redundancy payment or a PILON under their contracts of employment.
The Special Commissioner expressly rejected HMRC’s view that, where PILONs are made automatically to employees over a period of time, they should be taxed as earnings even if there is no contractual entitlement to them. He agreed that a payment could be taxable as earnings even if it was not contractual, but concluded that the fact a payment is habitually made will not on its own change its nature or source. As for HMRC’s view that ‘true’ damages payments are subject to mitigation, the Special Commissioner did not appear to regard this as relevant in determining the nature of a PILON.

This issue was not considered at all in the High Court (there was no appeal by HMRC in relation to the office staff). Having found that the PILONs paid to non-office staff were made under the employment contract, the Court declined to consider HMRC’s argument regarding PILONs paid automatically. It is, however, worth noting that one of the factors the Court took into account in reaching its decision in relation to the non-office staff was that there were no circumstances under which the PILON would be subject to mitigation.

The current position

As the law currently stands, the key question in deciding the tax and NIC treatment of a PILON is whether it was made pursuant to the employment contract (whether under an express or an implied term). Future challenges and court decisions will hopefully provide further clarification in this controversial area.

For more information, please contact Sara Cohen.

12th April 2007