Before you arrange any final payments, check the leaver’s contract of employment. The contract should specify:
Payment in lieu of notice
If you do not wish the employee to work for all or part of the notice period, you should make a payment in lieu of notice. Failure to do so will be a breach of the employee’s contract of employment and is likely to result in a claim for wrongful dismissal.
If you wish to pay in lieu and there is no specific clause in the contract allowing you to do so, you will technically be in breach of contract. However, provided you:
there will be no incentive for the employee to claim any damages for wrongful dismissal.
Where there is no payment in lieu of notice clause in the contract, it may be possible to make these payments tax free (up to a maximum of £30,000). This is because they may be regarded by HM Revenue & Customs as damages for breach of contract rather than earnings. The employee is only entitled to the amount of money he/she would have received had the contract not been breached. This would be the net amount, having made the appropriate deductions for tax and National Insurance. The employer can therefore choose whether to pay the full, gross amount to the employee or pay the net amount and retain the tax and NI deductions, which do not have to be paid to HM Revenue & Customs.
An employer’s ability to make a tax free payment of damages will, however, depend on custom and practice within the company. If it is normal practice to pay in lieu of notice, a pay in lieu term may be implied into the contract of employment and the payment will be taxable, even though there is no express clause in the contract.
Employers should think carefully about making a payment in lieu of notice when there is no contractual provision for doing so and the employee’s contract of employment contains any restrictive covenants. Restrictive covenants are designed to protect the employer’s business from unfair competition both during an employee’s employment and after its termination. The most common covenants cover:
If, by paying in lieu, you have technically breached the contract, you will be unable to enforce the restrictive covenant.
No such difficulty arises where the contract of employment contains a clause which entitles the employee to receive a payment in lieu of notice. In this case, however, the payment in lieu will be contractual and therefore taxable.
Some contracts of employment allow for a payment in lieu of notice to be made at the employer’s discretion. The contract may be worded so that the employer has the right to decide whether to make such a payment but is under no obligation to do so. In such a case, if the employer exercises discretion and makes a payment in lieu of notice, the payment will be taxable.
Whenever you are contemplating making any tax free payment to a leaver, it is always best to clear it in advance with HM Revenue & Customs. The taxation of final payments is a complicated area and you may also wish to take professional advice from an accountant.