Settlement agreements and tax

If you have been offered a settlement agreement by your employer, it can be difficult to decide whether to accept the offer of an agreed termination to your employment. Usually, a key consideration will be value of the financial compensation that you will receive under the terms of the settlement agreement.  Will this be adequate to allow you to transition into your next job, self-employment or retirement without unwanted financial stress?

This can be a difficult decision  and the thought of having to deal with the tax implications of receiving a settlement agreement payment may bring additional stress.

I have many year’s experience of advising Clients in your position and helping them to reach their bets outcome under their settlement agreement.  As part of this process I will explain the rules around settlement agreements and tax.

A settlement agreement may be subject to tax in England and Wales, depending on the type and value of the payments you receive as part of your settlement.

The settlement agreement offered by your employer usually consists of a variety of payments. There are certain payments that are taxable, while others are tax-free.

Some of the payments specified in your agreement will be part of your “remuneration” (pay/salary) and they will be taxable as pay. Typically, this would be Pay in Lieu of Notice (sometimes called “PILON”), the value of accrued but untaken holidays, bonus/commission payments and car allowance. Note this would not include any compensation for pension contributions which would have been made during your period of notice.

Compensatory or “ex-gratia” payments are not classed as renumeration and therefore treated differently for tax purposes. Note that it is no longer possible to reach an agreement with your Employer to reduce your period of notice and increase your compensatory payment. Disguising “pay” as “compensation” in this way will not fool the Inland Revenue and will simply create future problems for you and your employer. I always advise against this approach, even if is suggested by your employer.

Generally, the first £30,000 of your main settlement payment (sometimes referred to as a compensation payment or an ex-gratia payment) is tax-free.

When you’re leaving a job, HMRC classifies all payments you get from the company as “termination payments,” whether they’re redundancy payments, unfair dismissal compensation, pay in lieu of notice (PILON), holiday pay, or simply any wages owed.

Tax laws covering termination payments will apply if the payment is made because your employment is being terminated, regardless of the reason. A financial contribution towards the cost of your legal advice on the settlement agreement will not be taxable as a benefit to you. 

In cases involving a potential discrimination claim, a settlement agreement may include an element of compensation for “injury to feelings”. This type of compensation may fall within a tax exemption called the “disability exemption” which may apply when an employee is compensated for damages resulting from a psychiatric injury caused by unlawful discrimination.

If HMRC determines that your tax-free payment should have been taxed in full or in part, then they will contact your employer as the tax should have been deducted at source through PAYE.

The tax indemnity clause normally stipulates that if such a demand is made, you will indemnify your employer against it, which essentially means you will pay the tax demand if HMRC asks them to pay tax on that payment.

It is common for employers to use settlement agreements in redundancy situations, sometimes to avoid or short cut redundancy procedures.

On these occasions, if you are entitled to a statutory redundancy payment, your employer will usually include this in your settlement agreement.

Statutory redundancy payments are calculated by looking at your length of service, weekly pay and age. They are also subject to a cap, which changes each year. You can visit the government website to calculate your current entitlement (https://www.gov.uk/calculate-your-redundancy-pay)

Any statutory redundancy payment you receive can be paid tax-free in full.

Depending on your employment contract, you may be entitled to more than the statutory minimum if you are made redundant. This is known as a contractual redundancy payment.

The first £30,000 of a contractual redundancy payment is tax-free – anything over this amount is taxable.

It’s important to note that the £30,000 threshold applies to the total of the compensation payments you receive on termination of your employment.

If you receive a payment in lieu of notice (PILON), that payment is treated as salary and will be taxed as such.

If you don’t serve your whole notice period and you also don’t receive a PILON, then a percentage of your settlement payment will be treated as post employment notice pay (PENP). This is also treated as salary and taxed in kind.

There is no way to avoid paying tax on notice pay.

In most settlement agreements, you will be paid up to the termination date as normal. Since these wages are part of your earnings, they will be taxed in the usual way. Pay in lieu of Notice will be taxable in the same way as your usual salary.

Upon termination of your employment, you’re entitled to be paid for any holiday leave you haven’t taken. This also forms part of your taxable income, regardless of whether it’s paid under a settlement agreement.

I am a specialised employment law solicitor with over 35 years’ experience of helping Clients like you to conclude their settlement agreement quickly and efficiently. During my years of practice, I have developed extensive experience in supporting people to secure the best agreement possible settlement. I provide a fast, efficient and reliable service, finalising settlement agreements with even the most urgent deadlines.

If you would like support with your settlement agreement please complete my free enquiry form to arrange to discuss your case and run through what will happen next.