Understanding Pay in Lieu of Notice (PILON)

When employment relationships come to an end, one of the most important financial considerations is Pay in Lieu of Notice (PILON).

This payment occurs when an employer chooses to terminate employment immediately rather than having the employee work through their notice period.

While this might seem straightforward, the rules around PILON and its tax treatment can be complex and have undergone significant changes in recent years.

This blog explores the key aspects of PILON in the UK, including how it works, the tax implications, and what both employers and employees need to know.

What is Pay in Lieu of Notice (PILON)?

Pay in Lieu of Notice occurs when an employer pays an employee for their notice period but doesn’t require them to work during this time. For example, if an employee has a notice period of one month but the employer wants them to leave immediately, the employer would typically pay the equivalent of one month’s salary as PILON.

PILON can arise in various scenarios:

• When an employer wants a swift departure
• During redundancies
• In cases of settlement agreements
• Where continued employment might be uncomfortable for all parties

Types of PILON

There are two main types of PILON:

1. Contractual PILON: This occurs when the employment contract explicitly gives the employer the right to pay in lieu of notice. The contract typically specifies how this payment will be calculated.
2. Non-contractual PILON: This occurs when there is no contractual clause allowing for PILON, but the employer still chooses to make the payment. Historically, this was treated differently for tax purposes.

The current tax treatment of PILON

Prior to April 6, 2018, there was a significant distinction in how contractual and non-contractual PILON were taxed. However, the tax treatment has since been simplified.

Post-April 2018 rules

Since April 2018, all PILONs are subject to income tax and National Insurance contributions (NICs), regardless of whether they are contractual or non-contractual. This change was introduced through the concept of “Post-Employment Notice Pay” (PENP).

The key points of the current system are:

• All Basic Pay: The portion of PILON that represents basic pay (what the employee would have earned during their notice period) is always taxable as earnings.
• PENP Calculation: Employers must use a specific formula to calculate PENP, which determines the amount subject to income tax and NICs:

PENP = (BP × D) ÷ P

Where:

BP = basic pay for the last pay period before the termination date

D = number of calendar days in the post-employment notice period

P = any payments already made in the notice period

Practical implications for employers

Employers need to be aware of several important considerations when making PILON payments:

1. Accurate calculations: It’s essential to calculate PENP correctly to ensure proper tax treatment and avoid HMRC penalties.
2. Payroll processing: PILON payments should be processed through payroll with appropriate tax and NICs deductions.
3. Documentation: Clear documentation of how PILON was calculated should be maintained.
4. Reporting requirements: PILON payments must be reported on the employee’s P45 and through Real Time Information (RTI) submissions to HMRC.

Implications for employees

For employees receiving PILON, there are several important points to understand:

1. Tax withholding: Expect that income tax and NICs will be withheld from the PILON payment.
2. Final tax position: The final tax position might need adjustment at the end of the tax year, especially if the employee receives PILON early in the tax year and then remains unemployed.
3. Tax planning: Consider the timing of PILON if possible, as receiving it in a new tax year might be beneficial if the employee expects lower income in that year.
4. Checking calculations: Review the PILON calculation to ensure it correctly reflects the entitlement under the employment contract.

Special Situations

Redundancy packages

When PILON forms part of a redundancy package, it’s important to distinguish between:

• The PILON element (taxable as earnings)
• Statutory redundancy pay (tax-free up to £30,000)
• Other ex-gratia payments (potentially tax-free up to the remainder of the £30,000 allowance)

Settlement Agreements

In settlement agreements, PILON must be identified separately from other payments and taxed accordingly. The tax treatment of different elements of a settlement payment can vary significantly.

Foreign Service Relief

Since April 2018, Foreign Service Relief is no longer available for PILON payments, except for seafarers in certain circmisconceptions

Several misconceptions persist about PILON:

1. “PILON is always tax-free up to £30,000” – this is incorrect. PILON is always taxable as earnings.
2. “PILON calculations are based solely on basic salary” – the calculation should include regular payments but excludes benefits in kind, bonuses, and commission unless contractually guaranteed.
3. “Employers can choose how to structure PILON” – since April 2018, employers have less flexibility in how PILON is structured for tax purposes.

Recent developments and case law

Tax tribunals have addressed various aspects of PILON taxation in recent years. Key cases have clarified:

• The proper application of the PENP formula
• Treatment of contractual benefits during the notice period
• Interaction of PILON with other termination payments

Pay in Lieu of Notice represents an important financial element when employment ends. The tax treatment of PILON has been simplified since 2018, but careful calculation and proper treatment remain essential.

For employers, it’s vital to understand the rules to ensure compliance with tax obligations. For employees, understanding how PILON is taxed helps in financial planning during career transitions.