Payment in lieu of notice clauses are important. You either have one in your contract or you do not - the law will not imply a payment in lieu of notice clause into your contract of employment.

So what are they and how do they affect you? - This article explains all about payment in lieu of notice clauses and the taxation of pay in lieu of notice. We also advise whether a payment in lieu of notice is taxable or not.

[please note the taxation parts of this article are now out of date as the law has changed. A new article is being prepared]

Every employee is entitled to notice of dismissal unless he or she is guilty of gross misconduct. The amount of notice is:

• what is in the contract of employment; or
• If nothing is in the contract of employment then the notice period is a reasonable implied period. For the Chairman it might be six months or a year down to one week for someone lower down in the Company; or • The legal minimum period provided by the law if greater than either of the above.

The legal or statutory minimum notice period from the employer is nothing in the first month. Then for the remainder of the next two years it is a week. After that, it rises by a week per completed year up to a maximum of 12 weeks. So if the employee has served 8 complete years it is 8 weeks. If they have served 15 complete years it is 12 weeks. Only completed years count for these purposes.

In respect of notice if a company wants an employee to leave, it has a number of choices:

1. It can require the employee to work during the notice period. This means all pay and benefits are paid and are fully taxed. The question of payment in lieu of notice does not arise. This option is not often used in the case of senior or customer facing employees. The Company pays national insurance on the gross figure and pays that NI and the tax to HMRC and the net amount to the employee weekly or monthly during the notice period.

2. If it has the power to do so it can put the employee on garden leave. Tax and NI is treated in the same way as the employee working during the notice period. Even if the employer has no power in the contract to put the employee on garden leave most employers can still do so and get away with it. This is because it is only certain types of employee in certain types of employment who can successfully claim that the imposition of garden leave is a breach of contract.

3. It can make a payment in lieu of notice if it has the power to do so, even a discretionary power, in the contract. If it does make a payment in lieu of notice in this way, the whole payment is taxed. The Company pays national insurance on the gross figure and pays that NI and the tax to HMRC and the net amount to the employee in one go at the outset. Some companies’ contracts of employment are quite specific and allow the employer to pay the net payment in stages throughout what would have been the notice period. Some even have the right to reduce or stop such payments if the employee gets a job during what would have been the notice period.

4. It can dismiss immediately and pay damages for breach of contract in not giving notice. This is not a payment in lieu of notice. The amount of damages is the amount of money the employee would have received in his or her hand had he or she worked during the notice including benefits. Some companies, however, pay the gross amount of notice money thinking that because genuine damages for breach of contract can be tax free the employee should get the gross amount. In fact, this is wrong as the employee is only entitled to the net amount. If the total net amount is £30,000 or less the employer simply writes a cheque out for that amount. If the total net amount is greater than £30,000 the employer has to ‘gross up’ the excess over £30000 at the employee’s highest rate of tax to take into account the fact that the excess will be taxed. The effect must be that when all tax is taken of the employee is left with the correct net amount. Payments subject to the £30,000 tax free allowance are not subject to NI. This is real issue with some companies as they do not understand this.

5. It can negotiate before terminating and ‘do a deal’ with the employee. HMRC take the view that a negotiated payment in this way without any breach of contract is taxable if termination was not a real prospect at the time of the deal. We can advise if this can be avoided. A negotiated settlement of the notice pay when termination is a real prospect i.e. when you have been or are about to be dismissed can be tax free but the employee still gets the net amount.

If the employer does not have the power to make a payment in lieu of notice (‘PILON’) but claims to have done so, the payment is damages and the Company has breached the contract. This means that post termination restrictions fall away as unenforceable. We often see compromise agreements drafted in such a way as to suggest both that the notice pay is tax free (meaning the termination must be in breach) and that the post termination restrictions remain in force. Such inconsistency must be avoided as HMRC are aware of this issue and its internal guidance to tax inspectors specifically advises them to look for this.

An employer often pays an employee less than an amount, which would cover wages and benefits during the full period of notice. An employer’s argument is that the employee is able to mitigate his loss (an obligation that all departing employees have). He or she (and this is obviously particularly true of younger employees with long periods of notice) is only entitled to recover his “loss” and if the individual obtains alternative employment within the notice period, such loss will obviously be reduced. We regularly advise on this issue of mitigation and on the related topic of early receipt discount. Early receipt discount is the name given to the reduction in damages paid at the outset of what would have been the notice period. The discount reflects the value to the employee of getting the money up front in one go rather than in stages throughout what would have been the notice period. The amount of discount should reflect interest rates and the length of the notice period. It is often 1 to 3%. Both these points are important for companies subject to the Combined Codes for Corporate Governance. This is because the codes state that companies must be robust on the issue of mitigation.

The reason that mitigation sometimes becomes a dispute between the Company and the employee is not usually because the employer disputes that the employee is owed money but that it disagrees as to the amount. The Courts will, if necessary, decide when the employee could or should have got alternative employment but it is the amount of the deduction for mitigation (with optimism on the side of the employer against pessimism on the side of the employee) that is often the most controversial part of the negotiations as to an appropriate severance package. We are experts at negotiating severance or termination packages and will advise you quickly and efficiently on what you are entitled to. When we act for companies we can work out quickly and precisely what the departing employee is entitled to. This cuts down on negotiation and the consequent increase in legal costs.

For companies we can draft service agreements that provide for a mechanism for putting mitigation into use when terminating executives. For non-executive directors and companies we can review existing service agreements and advise on compliance with best practice.

Where there is a clause in the contract of employment providing for a payment in lieu of notice (or ‘PILON’) it gives certainty to both employer and employee as to the amount of compensation that the employee will receive upon the contract being terminated. There is one obvious disadvantage, which is that the payment made under such a clause is taxable in full and thus if it is used the employer loses the advantage of being able to rely on the £30,000 tax free allowance. One significant benefit to an employer of having a PILON in the contract is that using it to terminate employment means that the contract ends at that time properly and without breach. This is certain to keep alive ongoing obligations in the contract of employment that would otherwise fall by virtue of the breach of contract. Such obligations are often called restrictive covenants, which this firm is very experienced at both advising on and drafting for companies.

A simple example can illustrate this point. An employee is on £12,000 a year and has a month’s notice. His or her net take home pay is say £800 a month. If the Company makes the employee work during the notice period, puts him or her on garden leave or makes a payment in lieu of notice it costs the employer £1000 plus employers’ NI. If we say that the employer’s NI is 13.8% then the total cost to the employer is £1138 but the employee gets £800. If the employer breaches the contract if will not be able to rely on post termination restrictions unless it agrees separately that for a payment they will continue to apply. However, in the case of breach the cost to the employer is only £800 (because it simply pays the amount that the employee would have received had the contract been performed. This is a saving of £1138 - £800 or £338. We can advise on the correct form of wording to use when making this saving but it should be remembered that when an employee is on say £70,000 and 3 months’ notice the £338 equivalent saving is thousands of pounds. This is a big saving to a company and it is perfectly legal and appropriate. Remember that an employer can always choose to breach the contract and pay damages even if it has a contractual right to make a payement in lieu of notice. HMRC have issued specific guidance in Tax Bulletin 63 to explain its view on this subject and what it looks for in a deciding whether a payment in respect of notice is ‘damages’ or in fact is a payment in lieu of notice.

If you are an employee and are being dismissed by reason of redundancy don’t forget that as well as notice you have a right to a statutory redundancy payment if you have more than 2 years’ service and to any accrued but untaken holiday pay. You may also be entitled to an enhanced redundancy payment depending on the terms of your contract of employment and the custom and practice of your employer.

Other points – loss of the chance to claim unfair dismissal

An employee dismissed without being given the right period of notice is said to be ‘wrongfully dismissed’. If there is no contractual right for the employer to make a payment in lieu of notice then the employee has been wrongfully deprived of the benefit of remaining in work for the notice period. As the employee should, according to the contract, have remained in work during the notice period his or her employment has ended earlier than it should have done. In some cases, the notice period would have taken the employee over the one-year threshold for claiming unfair dismissal or the two-year threshold if employment started after April 2012. In such a situation the breach of contract by the employer has deprived the employee of the right to claim unfair dismissal. Between 1999 and July 2003 the law was such that an employee in these circumstances could claim as damages for breach of contract the amount of salary, benefits and bonus that he or she would have been able to claim as unfair dismissal had his or her employment lasted until he or she qualified for unfair dismissal. This was the decision of an appeal case called Raspin v United News Shops Ltd 1999 in which a shop assistant was dismissed three weeks before she would have been able to claim unfair dismissal. The case decided that an employee deprived of the ability to claim unfair dismissal in these circumstances could be awarded compensation as breach of contract damages. In July 2003, however this case was overruled by a new case called Virgin Net Ltd. v Harper. This case is good news for employers who can now wrongfully dismiss before the 1 or 2 year date is up even though the notice period would have taken the employee over the qualifying period.

There is one small point to make, however, about that case. It is that it made a distinction between cases where the complaint is about the dismissal being in breach of contract and cases where it is the conduct of the employer prior to dismissal that is in issue. The new case left open the prospect that Mrs Raspin type cases (conduct prior to dismissal) could still succeed in the future. Specific advice on this area should be taken.

The law on claiming damages for breach of contract for being deprived of a notice period remains the same. For example, this firm once concluded negotiations for a senior executive who had not remained an employee during his notice period would have been dismissed before he got to 2 years’ service. The problem for the executive was that unless he got to 2 years the Company would take back its generous pension contributions and refund his contributions after deducting tax. By negotiating with the Company and pointing out that it did not have a right to dismiss without notice we were able to ensure that the executive remained in employment and therefore secured the value of his pension benefits.

Summary

Payment in lieu of notice clauses are good news for employers in that they allow immediate termination within the terms of the contract. They can provide certainty at a time of dispute and can reduce the amount of money that to which an employee is entitled. A downside is that such a clause can reduce the ability of the Company to take advantage of the £30,000 tax-free limit.

Such clauses can sometimes be good news for an employee but mostly they reduce the scope for negotiation by employees. Employees commencing employment should check the proposed terms carefully and negotiate on the existence and content of such a clause. There are different considerations to weigh up as to whether to negotiate for or reject a payment in lieu of notice clause. If accepting such a clause the employee should seek to include the cash equivalent of any benefits.