This factsheet sets out the tax implications of a Compromise Agreement payment.
What are Compromise Agreements tax considerations?
Compromise Agreements are legally binding agreements between an employer and an employee, sometimes referred to as a termination settlement. Whether you are an employer letting staff go or an employee about to lose your job, Compromise Agreement advice from a solicitor is essential.
It is usual for a Compromise 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 Compromise 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 Compromise Agreement tax free, but this will not apply to all payments.
Compromise Agreements and Tax
How Compromise 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 Compromise Agreements may also include a consideration associated with a confidentiality clause. These are also subject to deductions.
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 Compromise Agreement clause to that effect.
Sums exceeding the £30,000 exemption
If the Compromise Agreement includes compensation that exceeds the £30,000 exemption, tax is deducted at basic rate on the additional amount. If the employee is liable for higher rates of tax they are responsible for accounting to HM Revenue & Customs for this.
How we can help
martin searle solicitors offers free online information and advice for employers and employees about Compromise Agreements. Trade unions and employers can also find out about the firm’s Compromise Agreement employment law service for multiple sign offs.
