This factsheet sets out the tax implications of a Settlement Agreement payment and answers the question: “Are Settlement Agreements taxable?”
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.
All usual payments made up to the point that employment ends are subject to deductions for tax and national insurance in the normal way.
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.
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 payments made for loss of office or loss of employment are exempt from tax on the first £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.
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.
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.
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.
Both statutory redundancy payments and contractual redundancy payments fall within the £30,000 tax free exemption.
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.
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.
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.
Martin Searle Solicitors offer free online information and legal advice for employers about Settlement Agreements tax and all other aspects of Settlement Agreements.