Factsheet: Settlement Agreement Tax Implications

1. What are Settlement Agreements tax considerations?
2. Salary and benefits to date of termination
3. Payment in lieu of holiday
4. What is pay in lieu of notice (PILON)?
5. Are Settlement Agreement legal fees tax deductible?
6. Compensatory and ex-gratia payments (non-contractual) payments
7. Payments for restrictive covenants and confidentiality obligations
8. Payments for Injury to Feelings
9. Payment on account of a Disability or Injury
10. Redundancy payments
11. Contributions to registered pension scheme
12. Outplacement costs
13. Legal costs
14. Sums exceeding the £30,000 exemption
15. Are Settlement Agreements Tax Free?
16. How we can help

What are Settlement Agreements tax considerations?

Settlement Agreements are legally binding agreements between an employer and an employee, formerly known as a Compromise Agreement. Whether you are an employer letting staff go or an employee about to lose your job, obtaining Settlement Agreement advice from a specialist Settlement Agreements solicitor is essential.

It is usual for a Settlement Agreement to be entered into either shortly before or after the termination of an employee’s employment. These agreements are sometimes used when redundancies are made, but they can be used in a number of situations.

A Settlement Agreement allows for a clean break of the employment relationship where you as the employee agree to waive your right to bring claims in return for an agreed sum or compensation. Generally speaking, your employer can pay the first £30,000 compensation for the Settlement Agreement tax free, but this will not apply to all payments. Tax on Settlement Agreement differs according to a range of considerations.

How Settlement Agreement payments are treated for tax purposes will depend on the basis on which they are paid.

Salary and benefits to date of termination

All payments made for the period up to the point that the contract of employment ends are subject to deductions of tax and national insurance in the normal way.

Payment in lieu of holiday

Very often, you will have holiday owing to you when your employment ends. Payments made in lieu of holiday are taxable.

What is pay in lieu of notice (PILON)?

Since April 2018, any payment in lieu of notice related to a Settlement Agreement must be subject to tax and national insurance deductions.

The government has created a statutory formula that should be applied to ensure that any outstanding notice pay due is paid subject to tax and national insurance.

Unless you have worked your full notice period, a Settlement Agreement should clearly state the amount of the payment in lieu of notice due.

Are Settlement Agreement legal fees tax deductible?

Generally, the legal fees incurred in instructing a lawyer to advise an employee on a Settlement Agreement will be paid by the employer, and the employee will not pay tax on these.

The employer’s contribution does not count towards the £30,000 tax exemption as long as it is solely connected with the termination of employment. It is usually paid directly to the lawyer rather than via the employee.

Compensatory and ex-gratia payments (non-contractual) payments

Compensatory, ex gratia (non-contractual) payments made for loss of office or employment are exempt from tax on the first £30,000.

Payments for restrictive covenants and confidentiality obligations

Your employer may wish to restrict you from acting in competition or approaching customers or employees once they have left the company. If the contract contains enforceable restrictive covenants, your employer will be able to rely on these if they have not breached the contract when terminating the employment.

However, sometimes the contract does not contain such provisions, or the contract contains restrictions that are too wide to be enforceable. If this is the case, your employer can seek new restrictions.

To make these binding in law, there must be a ‘consideration’ paid, usually of a small sum of £100-£200. This payment is fully taxable and liable to national insurance contributions.

Some Settlement Agreements may also include a consideration associated with a confidentiality clause. These are also subject to deductions.

Payments for Injury to Feelings

Payments made to compensate for injury to feelings arising from unlawful discrimination that occurred before the termination will not be taxable. Where the injury to feelings was caused by the termination they will be.

Payment on account of a Disability or Injury

A payment can be made free of tax where it is on account of a disability or injury (and also death). The payment must relate to the fact of the injury or disability and not any consequential effect on earnings.

Redundancy payments

Both statutory and contractual redundancy payments fall within the £30,000 exemption.

Contributions to registered pension scheme

Payments made direct into a pension scheme are treated separately and are not subject to tax. There are annual and lifetime allowances for contributions to registered pension schemes and contributions in excess of these allowances do incur tax charges.

Outplacement costs

Contributions to the cost of outplacement counselling or similar training are not taxable and are usually paid directly by the employer and therefore do not count towards the £30,000 exemption.

Legal costs

Usually, your employer pays for your legal costs. This does not count towards the £30,000 exemption as long as it is solely in connection with termination of employment, is paid directly to your solicitor and there is a specific Settlement Agreement clause to that effect.

Sums exceeding the £30,000 exemption

If the Settlement Agreement includes compensation that exceeds the £30,000 exemption, prior to 6 April 2011 tax was deducted at basic rate on the additional amount. If you were liable for higher rates of tax you were responsible for accounting to HM Revenue & Customs for this. Your employer now has to deduct tax at the OT tax code rate which may mean making deductions at different rates from 20% to 45% depending on the size of the excess. The OT Code does not include any personal allowances and divides the different tax bands into twelfths.

Are Settlement Agreements Tax Free?

Since April 2018, the Finance Act (2018) has made it clear that notice pay must always be taxed and subject to National Insurance. All Settlement Agreements require you to indemnify your employer on any excess tax which remains unpaid after termination. This means that if there is excess tax, you would have to pay. It is important that your legal adviser goes through the Settlement Agreement, to work out that the correct amount of tax is paid at the right time.

How we can help

Martin Searle Solicitors offers free online information and advice for employers and employees about Settlement Agreements tax and all other aspects of Settlement Agreements.

For expert advice on Settlement Agreements and tax implications, contact our Employment Law Team on 01273 609911, or email info@ms-solicitors.co.uk.