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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 Agreement tax considerations?
  2. Normal salary and benefits to date of termination
  3. Payment in lieu of accrued but untaken holiday
  4. Pay in lieu of notice (PILON)
  5. Compensatory and ex-gratia payments (non-contractual) payments up to £30,000
  6. Compensation sums over £30,000
  7. Payments for post-termination restrictions and confidentiality obligations
  8. Payments for Injury to Feelings
  9. Payment for a Disability or Injury
  10. Redundancy payments
  11. Contributions to registered pension scheme
  12. Outplacement costs
  13. Legal fees
  14. How we can help

What are Settlement Agreement tax considerations?

Settlement Agreements are legally binding agreements between an employer and an employee, formerly known as a Compromise Agreement. If you are an employer letting staff go, employment law advice from a solicitor is essential.

It is usual for a Settlement Agreement to be entered into either shortly before or after terminating an employee’s employment. These agreements are often used when redundancies are made, but they can be used in various other situations.

A Settlement Agreement allows for a clean break of the employment relationship where the employee agrees to waive their right to bring employment claims in return for an agreed sum. 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 Agreements differ according to a range of considerations.

How Settlement Agreement payments are treated for tax purposes will depend on what kind of payment they are.

Normal salary and benefits to date of termination

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

Payment in lieu of accrued but untaken holiday

Very often an employee will have holiday owing to them when the employment ends. Employers are obliged to pay employees in lieu of accrued but untaken holiday when employment is terminated. 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 a person’s employment contract  allows such payments to be made. This information could also be in an employee handbook rather than the written contract. Where the employee’s contract includes a clause allowing the employer to make a payment in lieu of notice (a PILON clause) , they will be taxable like other contractual payments. Where there is no PILON clause , they can be paid gross and will count towards the £30,000 tax-free exemption.

If it is the custom and practice of an employer to make a payment in lieu of notice  even if there is no PILON clause, 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 (non-contractual) payments up to £30,000

Compensatory payments made for loss of office or loss of employment are exempt from tax on the first £30,000.

Compensation sums over £30,000

If the Settlement Agreement includes compensation that exceeds the £30,000 tax free exemption the employer 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.

Payments for post-termination restrictions and confidentiality obligations

In order to protect their business 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 employment 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, if the contract does not contain post-termination restrictions, or the contract contains restrictions that are too wide to be enforceable,  the employer can seek new restrictions.

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

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

Payments for Injury to Feelings

Compensation for injury to feelings due to unlawful discrimination that occurred before the termination will not be taxable. If the injury to feelings was caused by the termination it will be taxable.

Payment for a a Disability or Injury

A payment can be made tax free 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 redundancy payments and contractual redundancy payments fall within the £30,000 tax free exemption.

Contributions to a registered pension scheme

Payments made direct into a pension scheme are not subject to tax. However, there are annual and lifetime allowances for contributions to registered pension schemes.  Contributions in excess of these allowances do incur tax liability.

Outplacement costs

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

Legal fees

The employer is usually expected to pay the employee’s legal costs. This does not count towards the £30,000 tax free 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.

How we can help

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

For further information and advice contact us today on 01273 609911, or email info@ms-solicitors.co.uk to speak to one of our expert employment lawyers.

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