This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Directors' service contracts.
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 – ie a claim for wrongful dismissal.
Payment in lieu provisions are particularly important where:
- the contract has restrictive covenants (see: Restrictive covenants in directors' service contracts, an OUT-LAW guide) – 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 HM Revenue & Customs 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 or 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 or the formula to calculate it. The company may wish to negotiate (or be seen to negotiate) a payment in lieu provision that does take some account of mitigation – ie 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. But if a director is to be employed on a lengthy notice period, a company may want 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.
- The instalment option is supported by the Joint Statement: ‘Phased payments are generally appropriate for fulfilling compensation on early termination. The ABI and NAPF are not supportive of the liquidated damages approach, which involves agreement at the outset on the amount that will be paid in the event of severance.’