With the current recessionary climate there has been a significant increase in redundancies and other dismissals.  This has led to an inevitable increase in the use of compromise agreements whereby an employee signs a document agreeing not to bring particular employment or contractual claims in exchange for a financial settlement.
Here we look at some of the key issues in considering how termination payments could be structured.

Payment in lieu of notice ("PILON")
Where possible, an employer will wish to structure the payment in the most tax efficient way, potentially seeking to take advantage of the £30,000 exemption (where payments at or below £30,000 are generally tax free if the payment is compensation for loss of employment).  Key considerations are:

  • If there is a PILON clause in the contract of employment, which is not discretionary, the payment will always be taxable.
  • If there is a discretionary PILON clause, it is open to the employer to demonstrate that it has not been invoked – but rather that there has been a demonstrable breach of contract.  In that case, the payment will be a damages payment, not a payment made under contractual PILON.   The employer would need to demonstrate a clear breach of contract and a decision not to pay PILON preferably in writing. They would also be required to show a different payment compared to the value of the PILON i.e. taking account of both salary and benefits (not just the calculation appearing in the PILON clause – which could be expressed as a payment by reference to basic salary only), and consideration of whether to build in a reduction for accelerated receipt of payment and the employee's obligation to mitigate his loss.
  • If no PILON clause appears in the contract and no automatic PILON can be established (i.e. the employer can show that payment is not an automatic response to termination) then any payment in lieu of notice is treated as damages for breach of contract and can take advantage of the £30,000 tax-free exemption (and no NI deductions on any of the payment. 

Redundancy Payments
The £30,000 exemption will also apply to redundancy payments that are statutory, non- contractual or contractual provided that it can be demonstrated there is a genuine redundancy situation.  Care must be taken where a redundancy payment is conditional on staying until a specified date or event. This is fairly common for senior employees.  The employer would have to show that the redundancy payment was genuinely to compensate the employee for loss of employment by reason of redundancy rather than a reward for services rendered.  Depending on the numbers of affected employees and the value of the redundancy payments it may be prudent to consider seeking advance clearance from HMRC where conditional redundancy payments are being proposed.

Ex-Gratia Payments
These must genuinely be compensation for loss of employment rather than a desire to reward previous loyal service if it is to attract favourable tax treatment. 

Payments exempt from tax

Examples of these would be payments for legal fees, outplacement costs, payments for death, injury or disability and contributions to pension schemes.

Tax considerations are important when seeking to terminate employment of a member of staff.  There are, however, other considerations such as retention of contractual restrictive covenants (for example, a clause which prevents the employee setting up immediately in competition with his former employer) and the ability to control what the potentially aggrieved employee can say to the employer's clients, staff and the marketplace.  It is recommended that employers seek professional legal advice to discuss objectives and how best to achieve them. 
Kim Pattullo is a partner specialising in employment law with leading UK law firm Shepherd and Wedderburn LLP.

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