Payment in lieu clauses in directors' service contracts
This guide is based on UK law.
Purpose
A payment in lieu clause allows an employer to terminate
someone’s employment instantly on making a payment in lieu of
salary or salary and benefits during a notice period or, possibly,
a portion of the salary otherwise due.
It means more flexibility for the employer, entitling a company
to bring an employment relationship to an end and quickly introduce
a replacement.
Without it, companies that dismiss with no notice are in breach
of contract and therefore at risk of legal action – i.e. a claim
for wrongful dismissal.
Payment in lieu provisions are particularly important where:
- the contract has restrictive covenants (see our OUT-LAW guide
on Restrictive covenants) – these cannot
be relied upon in cases of wrongful dismissal;
- the director holds equity in the company and the amount they
are entitled to be paid for a return of their shares depends on
whether they have been wrongfully dismissed/how long they have been
employed before termination.
Tax implications
Where a payment is made by a company under a payment in lieu
provision it is regarded by the Inland Revenue as an emolument
deriving from the employee’s employment contract. This means that
the £30,000 tax exemption for a severance payment will not be
available: the full amount of the severance payment (or at least
that portion representing the payment in lieu) will be liable for
tax and national insurance.
Negotiation points
Payment in lieu provisions need very careful drafting and will
frequently be the subject of negotiation. Advice should be sought
from an employment lawyer, but companies should bear in mind the
points below.
- It should be absolutely clear that payment in lieu will be at
the discretion/election of the company. Otherwise, a director will
be able to argue that they are automatically entitled to a payment
in lieu where the company chooses to terminate. The courts have
made clear that, where an entitlement under a payment in lieu
provision has arisen, an employee can receive the appropriate sum
as a debt without deduction for mitigation or accelerated receipt.
This means it is in the company’s best interests for payment in
lieu to be optional; in some circumstances, it may be preferable to
dismiss instantly and then negotiate a package taking proper
account of mitigation.
- Care should be taken when deciding the amount of the
payment/the formula to calculate it. The company may wish to
negotiate/be seen to negotiate a payment in lieu provision that
does take some account of mitigation – i.e. an executive’s likely
losses on termination. This is often achieved by including a
formula where a payment in lieu only reflects salary, not salary
and benefits. If a director is to be employed on a lengthy notice
period, a company may well wish, however, to include further
provision for mitigation. Another option is to draft the provision
so that the company can elect to make the payment in lieu in
instalments, the right to such payment terminating on the director
starting in a new position.
