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Pay in lieu - the new tax rules

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By Patrick Stewart

The tax treatment of monies paid by an employer to an employee in lieu of notice changed on 6 April this year. In doing so, an artifice much loved by employment lawyers will disappear. 

The pay/compensation distinction

Some employment contracts do not include a right for the employer to terminate the employee’s employment immediately and pay monies in lieu of notice. In such circumstances, where an employer does just that, he will be acting in breach of contract by not allowing the employee to work out the notice. Monies paid to the employee in lieu of notice will not be treated as income but as compensation for that breach of contract. As such, prior to 6 April, such monies were not taxable in the hands of the employee up to a limit of £30,000.

Contrast this with a case in which the contract of employment does include a right to make a payment in lieu of notice (a ‘PILON’ clause). Payments made by an employer to an employee pursuant to that clause will be treated as income from the employment, and taxable in full, together with liability for employer and employee National Insurance contributions.

The changes

For dismissals which occur after 6 April 2018, payments in lieu of notice – whether pursuant to an express PILON or compensation for breach of contract – will be taxable and subject to employee and employer National Insurance contributions. HMRC have devised formulas for calculating the taxable element.

It is worth noting that for these purposes, pay does not include overtime, bonuses, commission or benefits in kind. If the contract does not include a PILON clause, these sums could be paid without tax.

Why have a PILON?

The principal reason to retain a contractual right to pay in lieu of notice is to avoid the employer being in breach of contract by dismissing early and paying a lieu sum. If the employer is in breach in this way, then it can put at risk the enforcement of post-termination restrictions in the contract. For that reason it remains sensible to retain a PILON clause in a contract of employment, especially when dealing with senior staff for whom the benefit of post-termination restrictions are valuable.

Looking ahead, in April 2019 there will be further changes under which employers will have to pay employer’s National Insurance contributions on ex gratia payments which exceed £30,000. There will be no such charge to the employee. 

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