New rules were introduced on 6 April 2018 regarding the calculation of PILON tax and national insurance contributions.
Before the introduction of these new rules, the way in which payment in lieu of notice( PILON) payments were taxed and made subject to national insurance contributions depended largely on whether there was a PILON clause in the worker’s employment contract. If there was a clause, the PILON would be treated as a contractual payment and hence subject to tax and national insurance.
However, if the PILON was not mentioned in the employment contract, the employer could use the excuse of breach of contract and place the PILON payment within the £30,000 tax-free exemption.
The new taxation rules do not concern whether there is a PILON clause within the worker’s employment contract, and instead, all PILON payments are subject to tax and national insurance contributions.
This means that the basic pay an employee would have earned had they worked their notice in full is subject to tax.
What is PILON?
Notice is generally required to ensure a fair and lawful dismissal and termination of the employment contract. PILON, or payment in lieu of notice, can be used where it is necessary to terminate a worker’s employment immediately, rather than have that individual work their period of notice.
This can be beneficial and necessary in many circumstances, such as where the relationship with the employee has broken down and it would be impractical for them to continue work.
What are the PILON tax rules?
Under the PILON tax rules, employers have to calculate the amount of basic pay that the employee would have received if they had worked their notice period, and split the termination payment between amounts treated as earnings and amounts paid in compensation for loss of employment – which may benefit from the £30,000 threshold for tax exemption.
The calculation for the sum that should be taxed is a complex statutory formula known as ‘post-employment notice pay’ (‘PENP’). PENP is the salary the employee would have received during any unworked period of notice minus any contractual PILON.
The amount of PENP for an employee whose employment has been terminated is arrived at by using the PENP calculation.
How is PENP calculated?
The way in which PENP is calculated and the resulting tax and national insurance contribution liability will depend on the type of payments that are made on contract termination, for instance, whether the employer offers redundancy payments or negotiates a settlement agreement.
Where, as a result of their contract termination, the employee is only to receive PILON, this payment will be subject to taxation and national insurance contributions. In this instance, the PENP calculation is not required.
PILON and termination payments
Where on dismissal an employee is to receive PILON and also some form of termination payment, the PENP calculation must be used.
This calculation is:
((BP x D)/P) -T
where BP is basic pay, D is the days in the notice period, P is the days in the most recent pay period before this, and T is payment received as a result of the termination of employment that is taxable but not including holiday pay or bonuses.
The result of this calculation is the employee’s PENP, which will inform the taxable portion of the payment made to the employee and their national insurance contribution liability.
Where the employee is made redundant, any statutory redundancy payments will qualify for the £30,000 tax exemption, although enhanced redundancy payments will not.
What is an RTA?
RTA stands for ‘relevant termination award’. An employee’s RTA is the total payment received as a consequence of the termination of their employment. This does not include statutory redundancy payments but would include enhanced redundancy payments.
Once the PENP has been calculated, it is deducted from the RTA. The remaining amount qualifies for the £30,000 tax exemption and is not subject to a national insurance contribution liability.
If the RTA amounts to less than the PENP, then the whole RTA becomes subject to tax and national insurance contributions.
What should an employer consider when negotiating an employee exit?
There are several factors that an employer should take into consideration when negotiating an employee exit which involves PILON.
Is the PILON contractual or non contractual?
The new rules, introduced on 6 April 2018, disregarded the factor of whether PILON was mentioned in the employment contract of an individual whose employment was terminated, and made all PILON payments subject to tax and national insurance contributions.
However, there is still a difference in the way a PILON payment is handled in the PENP calculation depending on whether the PILON is contractual or not.
Under the PENP calculation:
((BP x D)/P) -T
T represents any payment received due to the termination of employment that is taxable but does not include holiday pay or bonuses.
Where the PILON is contractual, that is, there is a PILON clause in the employee’s contract, the amount of contractual PILON will be used for T.
Where the PILON is non contractual, that is, it is not mentioned in the employee’s contract, the amount of non contractual PILON is not used for T and does not factor in the PENP calculation at all.
It is therefore important that the employer is aware of this factor before calculating the employee’s PENP.
The seemingly complicated nature of the PENP calculation is mainly caused by the varying scenarios that may lead to its use and the individuality of each case.
Such factors may include:
- the length of notice period covered by PILON – should it be calculated in days, e.g. 31 days, or in months?
- the length of the pay period, again, should it be expressed in the number of days, or
- where the employee is paid on a monthly basis as ‘1’ for 1 month?
- whether the PILON is contractual or non-contractual and hence whether it is included in the PENP calculation
- what elements shouldn’t be included in the calculation, e.g. redundancy payments and non-contractual PILON
What are the reasons for the employee exit?
Will the employee be made redundant or have they been dismissed? The answer to this question will have certain ramifications for how any payments they receive as a result of their employment termination will be handled.
Where the employee has been dismissed and not made redundant, any payment received as a result of the termination of their employment is subject to tax and national insurance.
Where the employee has been made redundant, however, statutory redundancy payments will not be subject to tax and instead will qualify for the £30,000 tax exemption. This tax exemption will hence alter what is included in the RTA calculation.
Enhanced redundancy payments do not qualify for the £30,000 tax exemption.
Will the employee receive PILON alone or accompanying termination payments too?
Where the employee simply receives PILON on the termination of their employment, that payment is subject to tax and national insurance in the normal way and there is no need to use the PENP calculation.
Should the employee receive PILON but also receive other termination payments, the PENP calculation must be used.
This factor will therefore decide whether the PENP calculation is used or not.
When an employee is placed on gardening leave, that is, they remain in employment during their notice period but away from their usual business premises, they are not receiving payment instead of their notice period. Therefore, PILON does not apply.
PILON, PENP & settlement agreements
Employers will still need to calculate the PENP for each employee whose employment is terminating, including those employees whose contracts of employment contain a PILON clause. Employees are likely to want to see this calculation before signing any settlement agreement.
Does PILON have an impact on pensions?
Generally, once an individual’s employment is terminated, any related benefits such as a pension come to an end. Therefore, pension contributions to that individual would cease on their last day and not continue throughout the notice period that they would usually have worked.
Guidance for employers
With the current rules removing any tax advantage an employer may have had in not including a PILON clause in employment contracts, it is now recommended to add such a clause.
A PILON clause within the contract of employment allows PILON to be made without being in breach of contract, which will preserve any post-termination restrictions.
The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal advice, nor is it a complete or authoritative statement of the law, and should not be treated as such. Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission. Before acting on any of the information contained herein, expert legal advice should be sought.