A compromise agreement often sets out a number of different types of payments to the employee.
Some of these payments must be subject to tax but others are tax exempt. It's important that your employer gets it right or you could end up paying too much tax.
Whether or not a payment is taxable will depend on the nature and amount of the payment and so it's important to ascertain why the payment is being made and all the background facts.
The following payments will generally be paid subject to tax:
• Sums that you are contractually entitled to or which relate to past or future service. These are generally taxable in full They include:
- salary payments (including during garden leave);
- contractual bonus or commission;
- contractual payments in lieu of notice (also known as PILONS); and
• Consideration for entering into restrictive covenants. This is taxable in full
The following payments will generally be paid tax free:
• Non-contractual payments made as a result of the termination and redundancy. The first £30,000 is tax-free
• Employer contributions to registered pension schemes. These may be made tax free subject to the annual contribution limit.
Provided the payments are made direct to the service provider, the following payments can also be paid tax free
• Legal fees in connection with the compromise agreement.
• Outplacement counselling.
• Re-training.
What about a Payment in Lieu of Notice ("PILON")?
Whether or not a PILON can be paid tax free depends on whether or not it is contractual. If it isn't, it can be paid tax free.
However, HM Revenue and Customs take the view that, where an employee receives a contractual payment in lieu of notice (PILON), it is chargeable for tax as earnings from the employment.
A contractual PILON is one that has its source in the contractual arrangements between employer and employee. Such arrangements can take a variety of forms, including:
• the main contract document
• a side letter to the main contract document
• a staff handbook
• a letter of appointment
• a redundancy agreement
• an employer-union agreement.
It is important to consider all possible contractual sources.
In some circumstances a PILON may be taxable even if there is nothing written down in the employment documentation. For example, it may be the usual practice of an employer to make a PILON, even though nothing is written down. If HMRC take the view that this is your employer’s usual practice, some of the termination payment may be subject to tax.
If any of the payment is taxable, you will ultimately be responsible for paying it. If HMRC recover the tax from your employer, then your employer will have the right to claim it from you. However, they may decide not to do so on the basis that they had notified you that it would be tax free.
