Termination Payments Taxable if Not Damages

When a new executive fell out with the chief executive officer of the company he worked for, his employment was terminated without notice.

In such circumstances, a breach of contract occurs. The executive’s contract of employment provided that should it be terminated for reasons not connected with ‘conduct or performance’, he would receive a Payment in Lieu of Notice (PILON) equivalent to 12 months’ salary plus some additional benefits. PILONs are taxable as remuneration. Payments of damages, however, are not taxable.

After considerable negotiation, the executive accepted a payment which was less than the PILON provided in his contract. The payment was made under a compromise agreement, which is an agreement between an employer and a departing employee that the employee will give up the right to take legal action against the employer in exchange for a payment.

Under UK tax law, the first £30,000 of a payment made as a result of a termination of employment is tax free. However, a PILON made under a contractual provision is not subject to this exemption.

The executive claimed that his payment was made in consequence of the termination of his employment and the £30,000 exemption therefore applied. HM Revenue and Customs (HMRC) disagreed, claiming that the payment was a PILON and was therefore taxable in full. HMRC won.

Critical to the decision was that the negotiations between the two parties were aimed at securing the PILON specified in the contract and that the amount received had been calculated in accordance with that, rather than in terms of damages for breach of contract.