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Factsheet: Settlement Agreement Taxation Implications

This factsheet sets out the taxation implications of a Settlement Agreement payment for employers and answers the question: “Are Settlement Agreements taxable?”

  1. What are Settlement Agreement taxation 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. Are Settlement Agreement legal fees tax deductible?
  15. How we can help

What are Settlement Agreement taxation 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, specialist Employment Law advice for employers from a solicitor is essential.

If you are in search of advice from the perspective of an employee, please read the following page – Settlement Agreement tax implications for employees.

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 where there are conduct or capability issues.

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

Generally speaking, you can pay the first £30,000 compensation for the Settlement Agreement tax free, but this will not apply to all payments. Taxation on Settlement Agreements differ according to a range of considerations.

How Settlement Agreement payments are taxed will depend on what kind of payment they are, as detailed below.

Normal salary and benefits to date of termination

All usual payments made up to the point that employment ends are subject to deductions for taxation 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 relationship ends. You are obliged to pay your 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)

Since April 2018, all payments in lieu of notice (PILON) must be subject to taxation and national insurance.

This is regardless of whether or not there is a PILON clause in your employee’s contract of employment, which therefore closes this former taxation loophole.

In addition, there is a new statutory formula that must be used to ensure that the correct amount of notice pay is taxed.

It is therefore important that a Settlement Agreement clearly states the amount of notice, or outstanding notice, that is due.

Where a settlement is negotiated after a gross misconduct dismissal or where your employee has resigned, with immediate effect, the notice period must be paid as a taxable payment and cannot be included in the £30,000 tax free compensation payment.

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 taxation on the first £30,000.

Compensation sums over £30,000

If the Settlement Agreement includes compensation that exceeds the £30,000 exemption, you have 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 your business, you 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, you 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, you 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 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 effect on earnings.

Redundancy payments

Both statutory redundancy payments and contractual redundancy payments fall within the £30,000 exemption.

Contributions to a registered pension scheme

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

Legal fees

You are usually expected to pay your 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 your employee’s solicitor and there is a specific Settlement Agreement clause to that effect.

Are Settlement Agreement legal fees tax deductible?

Generally, an employer will pay the legal fees incurred to instruct a lawyer to advise an employee on a Settlement Agreement. Any VAT charged by the independent legal adviser is not recoverable to the employer, although the employer’s contribution is classed as a business expense and is therefore deductible for corporation tax purposes.

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 expert advice on Settlement Agreements and tax for employers, contact our Employment Law team on 01273 609911, or email

Martin Searle Solicitors, 9 Marlborough Place, Brighton, BN1 1UB
T: 01273 609 991

Martin Searle Solicitors is the trading name of ms solicitors ltd, which is authorised and regulated by the Solicitors Regulation Authority, and is registered in England under company number 05067303.

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