Relief for Employers - Taxation of Termination Payments
Sunday, October 01, 2006
by
Michael McLaughlin
In recent years, the HM Revenue & Customs (“HMRC”) has vigorously pursued termination payments which had historically been regarded by employment lawyers and HR professionals as not taxable. A recent decision of the Special Commissioners of the Inland Revenue represents a setback for HMRC and provides greater comfort for employers when making termination payments.
Before dealing with the setback for HMRC that this case represents, there is another aspect of the case that is worthy of note. The perceived wisdom had been that if a contract of employment permitted an employer to make a payment in lieu of notice (“PILON”) then that payment was a benefit derived from employment and therefore taxable under the PAYE rules. On the other hand if no such provision exists then the payment is actually compensation for the employer’s failure to provide notice and therefore tax-free up to £30,000.
The decision in SCA Packaging Limited v HMRC emhasises that the test is not whether or not there is a PILON clause but is the payment is derived from employment. If it is from employment it is taxable, if it is not then it is tax-free. After all, argue HMRC, there are payments which are not contractual but which are nevertheless taxable such as tips or discretionary bonuses.
Payments made under PILON clauses are regarded as arising from the employment relationship itself and are taxable. Non-contractual PILON payments have traditionally been regarded as compensation payments for termination of employment and therefore not from employment. After all such payments do not arise from employment but from the termination of employment…or so it was thought.
HMRC was not content and has sought in recent years to declare non-contractual PILON payments as payments arising from employment. HMRC published a guidance note in 2003. The guidance note stated that if an employer’s made PILON payments as an “automatic response” to dismissal that could be regarded as a payment derived from employment and therefore taxable. It did not matter, said HMRC, that there was no PILON clause. If the employer was in the habit of making PILON payments on termination without negotiation with individual employees that was enough to render the payment from employment.
The guidance gave the example of an employer affecting multiple redundancies with all employees receiving a payment in lieu of notice. That would, they said, be regarded as an automatic response and therefore those PILON payments would be taxable. As a result of this approach, many employers opted to take the safety first approach deducting tax from any PILON payment irrespective of whether there was a PILON clause in the contract.
In SCA Packaging Limited it was ruled that the fact that an employer habitually makes PILON payments does not of itself mean that those payments are from employment. If the habitual practice does not amount to an implied contractual term through custom and practice then it is not rendered taxable.
The position is therefore clearer. If there is no PILON clause and an employee is dismissed without being permitted to work out his or her notice but instead receives a PILON payment then that payment arises out of termination of employment and not the employment relationship itself and is not taxable unless the payment exceeds £30,000.
HMRC remain convinced however that many non-contractual PILON payments arise from employment and it is anticipated that they will continue to pursue future cases.