The decision related to payments made in 2011 to professional footballers Wilson Palacios and Peter Crouch by Tottenham Hotspur Football Club.
The footballers had contracts with the club which expired on a fixed date unless terminated earlier by mutual consent. In 2011 the club wished to reduce its wage bill and so agreed to pay the footballers a lump sum for agreeing to the early termination of their contracts to join Stoke City Football Club.
HM Revenue & Customs (HMRC) argued that the payments were general ‘earnings from an employment’, subject to income tax and national insurance contributions (NICs), rather than payments in consequence of the termination of employment which would not have been subject to NICs and of which the first £30,000 would be tax free.
HMRC argued that the fact that the employment contracts included clauses expressly allowing for early termination of their fixed terms only by mutual consent was sufficient to mean that the agreed termination payments were 'from an employment'.
The Upper Tribunal upheld the earlier decision of the First-tier Tribunal that the payments were not general earnings.
"This is a helpful clarification that just allowing for the possibility of early termination is not enough to make a subsequent termination payment taxable as earnings," said Chris Thomas, an employment tax expert at Pinsent Masons, the law firm behind Out-Law.com. "However, it is important to note that the outcome would have been different if the contract had actually included provision for a payment to be made, as that would effectively have been a contractual PILON, and taxable accordingly. Nor does this case change the general principle that payments envisaged in the employment contract will be earnings – it is specific to this particular situation."
A PILON is a payment made to an employee when employment is terminated without giving the employee as much notice as he or she is entitled to under the contract, instead of the employee working through a notice period and receiving pay in the normal way.
In the Upper Tribunal Sir Geoffrey Vos and Judge Tim Herrington said: "If HMRC were right that any contractual provision allowing early consensual agreement for a termination is sufficient to make the termination payment made under the resulting agreement 'from an employment', that would cover almost every termination payment agreed in respect of a fixed term contract, because there is nearly always going to be an express or implied right to agree an early termination".
"Although the background to the payment may be the employment contract, the payment itself is not from the employment, but rather in consideration of the termination of the employment. If the payment is an agreed payment in lieu of notice paid in pursuance of an express term, that is a different matter," the judges said.
Chris Thomas said: "the significance of this case is likely to be short-lived. From April 2019, employer's NICs will be charged on ex gratia termination payments over £30,000. In addition, new rules on the taxation of deemed PILON payments which are coming into force in April 2018 will catch any payment which compensates for termination without due notice - although only in respect of basic pay - and any NICs advantage will also be lost."
Under the current system PILONs which are provided for in a contract of employment are subject to income tax and NICs, but non-contractual PILONs are not. The distinction between contractual and non-contractual PILONs will be removed from April 2018, meaning tax will be due on all payments equating to notice pay. The legislation in relation to PILONs is contained in the Finance (no 2) Act 2017, which recently completed its progress through the UK parliament.
The government intended to also change the NICs position for termination payments from April 2018, so that all termination payments in excess of £30,000 would be subject to employer's NICs. However, it announced in November that the National Insurance Contributions Bill, which will introduce the NIC charge in respect of termination payments, has been delayed and will take effect from April 2019, rather than April 2018.
"It is important to note that although the introduction of the NIC charge on termination payments has been deferred until 2019, the application of NICs to deemed PILONs has not," Thomas said.