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Factsheet: Settlement Agreement Tax Implications

This factsheet sets out the tax implications of a Settlement Agreement payment and answers the question, “Are Settlement Agreements taxable?”

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

It is usual for a Settlement Agreement to be entered into either shortly before or after 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 the employee agrees to waive their right to bring claims in return for an agreed sum, or compensation. Generally speaking, employers 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 an employee will have holiday owing to them when the employment ends. Payments made in lieu of holiday are taxable.

Pay in lieu of notice (PILON)

Whether pay in lieu of notice is taxable depends on whether such payments are allowed for in a person’s contract of employment. This information could also be in an employee handbook rather than the written contract. Where they are allowed, they will be taxable like other contractual payments. Where they are not, they can be paid gross and will count towards the £30,000 exemption.

Where it is the custom and practice of an employer to make a payment in lieu of notice (PILON) even if it is not part of the contract, HM Revenue & Customs may consider that tax should be deducted. The question is whether payments are made automatically or considered on each occasion.

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

An employer may wish to restrict an employee from acting in competition or approaching customers or employees once they have left the company. If the contract contains enforceable restrictive covenants, the employer will be able to rely on these if it has 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, the 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 affect 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 the employer pays the employee’s 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 the employee’s 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 the employee was liable for higher rates of tax they were responsible for accounting to HM Revenue & Customs for this. The 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.

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.

 

To speak to an expert employment lawyer contact us today on 01273 609911, or email info@ms-solicitors.co.uk.

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