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Compromise Agreements and tax

If you have been offered a Compromise Agreement to terminate your employment, you must ensure that your solicitor understands how payments will be taxed. Often the agreement can be worded differently to save you money. In this article, Andrew Crisp, an employment law solicitor, explains how it works.

The basic position is that compensation for loss of employment is not taxable up to a maximum of £30,000.00. This includes any redundancy payment.

Any payments due under an employment contract are taxable. This will include salary up to the date of termination, payment for accrued but untaken holiday as well as bonus and commission payments.

But what happens when the Compromise Agreement provides that the employee will receive a sum of money instead of working a notice period? This is known as a Payment in Lieu of Notice (PILON).

If the employee works the notice period, the salary is taxed in the normal way. Unfortunately, the position is less clear with a PILON. Is it taxable as a payment under the employment contract or is it a tax free compensation payment for loss of employment?

The issue is determined by whether or not there is a clause in the employment contract allowing the employer to make such a payment, known as a PILON clause.

If there is no PILON clause in the employment contract, the position is straightforward. Any PILON in the Compromise Agreement is not classed as a payment under the employment contract. The employer is deemed to be breaking the employment contract by not allowing the employee to work his notice. The payment is classed as compensation for breach of the employment contract and can be paid tax free up to £30,000.00.

The position is different if the employment contract does contain a clause allowing the employer to make a PILON. If an employer has a discretionary right to make a PILON and chooses to do so, the payment will be subject to tax. It is deemed to be a payment made under the employment contract.

If however the employment contract gives the employer the discretion to make a PILON but the employer chooses not to do so and pays compensation instead, it may still be deemed to be taxable as a PILON. This is more likely when the compensation payment is substantially the same value as a PILON would have been.

Compromise Agreements often state unnecessarily that tax will be deducted from the PILON. When you choose a solicitor to advise on your Compromise Agreement, you must ensure that they are fully familiar with the way that termination payments will be treated for tax. It may be that, with a bit of re-wording, you could save thousands of pounds!