Esther Smith, partner at Thomas Eggar, and Martin Brewer, partner at Mills & Reeve, advise on whether an employee, when made redundant, is owed a tax-free payment in lieu of notice.
The question:
We have just made one of our employees redundant. We terminated his contract and gave him pay in lieu of notice, plus holiday up to termination date and an SR Payment, plus bonus due.
He is claiming that the company owes him holiday for the unspent notice period of 14 weeks, plus the PILON payment should be tax free – as the PILON clause is not part of his contract.
I am positive that we do not owe him holiday pay for the notice period. Perhaps I am mistaken? All the redundancies in the past have signed CA’s – therefore making the notice tax free. We have offered a compromise agreement to make it tax efficient but he has refused as he believes that under the normal redundancy, he would be owed this amount anyway.
Legal advice:
Esther Smith, partner, Thomas Eggar
You are correct in saying that the employee is not entitled to payment for holiday for the notice period. Holiday is not an additional benefit in this sense, but is simply the right to take time off work without losing payment. Therefore, if he had worked his notice (or not been dismissed) he would not have received additional money for his holiday, but would have been able to take time off during working hours without losing pay.
On the issue of taxation treatment, I am a little concerned by what you say about paying notice without deduction of tax simply because the employee has signed a compromise agreement. The taxation treatment of a payment in lieu of notice is not affected by whether or not there is a compromise agreement in place, but whether the notice pay is properly taxable under the terms of the contract of employment.
If a payment of lieu is made in the absence of a contractual entitlement, the money paid to the employee is technically damages for breach of contract (the employer is doing something which it does not have the right to do under the contract) and therefore legally the payment of damages can be paid without deduction of tax and national insurance.
So, if there is no pay in lieu of a notice clause as is the case here, the employer could pay the notice without deduction. However, you are not obliged to do so. If the employee believes the sum is not subject to tax he can take this up with the revenue himself and seek to get the money repaid (if you have ever tried to get money back from the revenue you will know this is not that easy) but there is no obligation on the employer to pay the sum gross.
Esther Smith is a partner in Thomas Eggar’s Employment Law Unit. For further information, please visit Thomas Eggar.
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Martin Brewer, partner and employment law specialist, Mills & Reeve
This is, in part, complicated so forgive the jargon. First, whether pay in lieu of holidays, which would have accrued in the notice period, is payable is a matter of contract. So you need to look at what your contract says.
The taxable status of the PILON is more complex. Let’s get something out of the way first. The fact that there is a compromise agreement is irrelevant. The mere fact that you have entered into such an agreement does not of itself change the tax status of the payment you make. The only question HMRC is interested in is what is the true nature of the payment.
If a PILON is pay, i.e. you have the right or obligation under the contract to pay in lieu, or if you automatically make a PILON in every case (a so-called auto-PILON clause will be implied here) then the payment is taxable as employment income.
If you don’t have a PILON clause then the PILON is in reality a payment of damages for breach of contract – breach of the employee’s right to work their notice period in which case the PILON is damages and is tax free up to £30,000 (although do remember that this £30,000 is an aggregate figure so the SRP is included in the calculation).
Having said that, I suspect that hidden in your question is a classic misunderstanding of what ‘tax free’ means. What your now ex-employee is saying is not only should the payment be tax free but that he should therefore receive the gross figure. But that is just wrong. Damages are designed to put the employee in the position he would have been in had the contract been fulfilled. In this case, if the employee had worked his notice he would have received net pay, not gross pay. Therefore the correct measure of damages for a non-contractual PILON is still net pay. All that ‘tax free’ means is that you, the employer, do not have to pay the tax over to HMRC.
Martin Brewer can be contacted at martin.brewer@mills-reeve.com. For further information, please visit Mills & Reeve.
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