Payments in Lieu of Notice, commonly known as PILON, are payments made by an employer when they wish to terminate an employee’s contract immediately rather than requiring the employee to work through the notice period. In exchange for waiving this notice period, the employer compensates the employee for the time they would have worked if they had been allowed or required to serve out their notice.

PILON has specific tax implications under UK law, which changed significantly in 2018 to treat most PILON payments as taxable income. Here’s an in-depth look at how PILON payments work, how they’re taxed, and what this means for employees.

1. What is PILON?

PILON stands for “Payment in Lieu of Notice.” It compensates an employee for the notice period they would have worked if they were not terminated immediately. This is commonly used when:

• The employer wishes for a swift end to the employment relationship and does not want the employee to work through the notice period.
• There may be a potential conflict, risk, or reason for a swift transition.
• There is a need to protect sensitive information, relationships, or operational functions by ending the employment immediately.

For example, if your employment contract specifies a three-month notice period and you earn £3,000 per month, a PILON payment would amount to £9,000, covering the three months’ salary you would have received if you had worked through the notice period.

2. Taxation of PILON Before and After 2018

The tax treatment of PILON changed significantly with the Finance Act 2017, which introduced new rules effective from April 2018. Understanding these changes is essential, as they have a direct impact on whether PILON is subject to income tax and National Insurance Contributions (NICs).

Before April 2018

• Contractual PILON: If an employment contract explicitly included a PILON clause, the payment was taxable as it was deemed a contractual payment.
• Non-Contractual PILON: If the contract did not mention PILON, payments could sometimes be classified as non-contractual, allowing them to be considered as part of a tax-free termination payment (up to the £30,000 limit).

This distinction allowed some PILON payments to qualify for the tax-free treatment under the £30,000 exemption, particularly if they were viewed as ex-gratia (voluntary) payments related to termination rather than contractual earnings.

After April 2018

• The Finance Act 2017 removed the distinction between contractual and non-contractual PILON.
• All PILON payments are now treated as taxable income, regardless of whether they are specified in the employment contract.
• The law introduced the concept of Post-Employment Notice Pay (PENP), which is calculated to ensure that employees are taxed on the portion of their settlement payment that represents notice pay, even if there is no contractual PILON clause.

Key Point: Under the current rules, all PILON is considered taxable income and is subject to both income tax and NICs. There is no tax-free element for PILON under the £30,000 tax exemption.

3. What is Post-Employment Notice Pay (PENP)?

Post-Employment Notice Pay (PENP) is a formula used to calculate the taxable amount of PILON when an employee leaves without working their full notice period. This calculation was introduced to ensure fairness in taxation and to eliminate the previous tax loophole for non-contractual PILON.

The PENP formula determines the amount of notice pay an employee would have received if they had worked through their notice period. The calculation is as follows:PENP=(Basic Pay×Notice Period Remaining)−Any Pay Received for NoticePENP=(Basic Pay×Notice Period Remaining)−Any Pay Received for Notice

Where:

• Basic Pay is the employee’s monthly salary before the termination.
• Notice Period Remaining is the amount of time (in months) that the employee would have worked if given full notice.
• Any Pay Received for Notice is any payment or benefit the employee received during the notice period.

The PENP calculation ensures that any amount representing lost notice pay is treated as taxable earnings, regardless of the presence of a PILON clause in the employment contract.

Example of PENP Calculation:

• Scenario: An employee with a monthly salary of £3,000 has a three-month notice period but is terminated immediately and receives no PILON.
• PENP Calculation:
  • PENP = (£3,000 × 3) – £0 = £9,000
• Tax Outcome: The £9,000 is classified as taxable income and subject to both income tax and NICs, just as it would have been if the employee had worked through their notice period.

4. How PILON Payments Are Taxed in Practice

All PILON payments are subject to tax as regular income. This means that they are:

• Subject to Income Tax: At the employee’s normal income tax rate.
• Subject to National Insurance Contributions (NICs): NICs are also payable on PILON, just as they are on regular earnings.

Key Point: The entire amount of PILON is taxed, and there is no possibility of applying the £30,000 tax-free exemption that is sometimes available for termination payments not related to notice pay.

5. How PILON Differs from Other Tax-Free Termination Payments

It’s essential to distinguish PILON from other payments within a settlement agreement that may qualify for tax-free treatment. While PILON is taxed as income, other types of compensation may fall within the £30,000 tax-free exemption, including:

• Redundancy Payments: If the payment qualifies as statutory or enhanced redundancy pay, it can be tax-free up to £30,000.
• Ex-Gratia Payments: Discretionary or goodwill payments not related to contractual obligations, such as compensation for loss of employment, may also be tax-free up to the £30,000 threshold.

PILON is treated differently from these payments because it represents earnings that would have been received if the employee had worked their notice, whereas redundancy and ex-gratia payments are considered compensation for termination.

6. Structuring Your Settlement Agreement to Maximize Tax Efficiency

Since PILON is fully taxable, it’s wise to work with a solicitor to structure the settlement agreement in a way that maximizes tax efficiency. Here are some strategies to consider:

a) Maximize Tax-Free Elements

Where possible, allocate payments toward tax-free elements, such as redundancy or ex-gratia payments, which qualify for the £30,000 tax-free exemption. However, this is only feasible if the payments are genuinely for these purposes and not related to notice.

b) Consider Timing and Amount of Payments

If there are additional payments that do not directly relate to notice, your solicitor can help ensure they are structured to fall under the tax-free categories, rather than being grouped with PILON.

c) Confirm Compliance with PENP Rules

Make sure that any compensation related to lost notice pay is accurately classified as PILON to avoid penalties or tax complications. A solicitor can help verify that the settlement agreement complies with PENP rules and the correct tax treatment is applied.

7. Frequently Asked Questions about PILON Taxation

Can my employer offer PILON as a tax-free payment?

No, under current tax laws, PILON is taxable as regular income, and it cannot be categorized as tax-free compensation, regardless of whether it’s contractual or non-contractual.

Is it possible to reduce my tax on PILON?

Since PILON is subject to income tax and NICs, reducing the tax on this payment is challenging. However, working with a solicitor can help maximize the tax efficiency of other parts of the settlement agreement, potentially reducing the overall tax burden.

Are there penalties for misclassifying PILON?

Yes, misclassifying PILON as tax-free can lead to penalties from HMRC for both the employer and employee. It’s essential to ensure that PILON payments are correctly taxed to avoid complications.

Final Thoughts: PILON Taxation and Your Settlement Agreement

Understanding the tax implications of PILON is crucial, as it affects the final amount you receive from a settlement agreement. Under UK law, all PILON payments are treated as taxable income, meaning you should expect income tax and NICs to apply. By working with a solicitor, you can ensure that the settlement agreement is structured to maximize tax efficiency where possible, potentially increasing your take-home amount from other tax-free payments in the settlement.

While PILON taxation is straightforward under current rules, each settlement agreement is unique, and professional advice is invaluable in ensuring compliance and securing the best outcome.