Ex gratia payments to employees – a quick guide

In this article we take a look at what an “ex gratia” payment is, when ex gratia payments to employees are commonly made, what sums under a settlement agreement generally are and are not taxed, and how you can make your settlement agreement most tax-efficient via the use of ex-gratia payments.

1. What is an ex-gratia payment?
2. Are ex gratia payments taxable?
3. Ex-gratia payments and Payments In Lieu Of Notice (“PILON”)
4. Pensions and tax efficiency
5. Ex-gratia redundancy payments
6. Compensation for discrimination
7. Redundancy payments and ex gratia compensation
8. Tax indemnity clauses in settlement agreements

An ex gratia payment is a payment made by an employer where there is no contractual obligation to do so – it is derived from the Latin: “out of kindness” (used to mean done as a favour and without legal obligation).

Ex gratia translates to ‘by favour’ and literally means a voluntary payment or a gift. In Settlement Agreements these payments indicate a sum that is paid without admission of liability by the employer and the use of the term ‘ex-gratia’ specifies to each party that the employer does not consider that they are under an duty to provide this amount.

How are ex-gratia payments offered to employees?

When an ex-gratia payment is offered to you by your employer they will generally (although not always) use the following phrases when making the offer:

• That it is a “without prejudice” offer
• That they are offering you a “severance package” or an “exit package“
• That they want to have a “protected conversation” or “pre-termination discussion” with you

Your employer will make the offer to you verbally (e.g. in a face-to-face conversation) or in writing (n an email or a letter). If your employer doesn’t put the offer to you in writing then ask them to do so (so you have clarity on what they are offering to you and what you should be expecting to receive).

Further reading: what does without prejudice mean and when should it be used?

Are ex gratia payments to employees taxable?

Payments that are made between an employer and employee are normally subject to tax as they will be described as ‘arising out of the contract of employment’ by HMRC.

Ex gratia payments to employees are an exception to that rule and fall under a tax exemption from s.403 Income Tax (Earnings and Pensions) Act 2003 for any amounts under £30,000.00. This is because the payments made are not made for the work that has been undertaken or for a provision of services; they are a “voluntary” payment made by the employer and are “compensation for loss of employment”.

Any ex-gratia payment over £30,000.00 should be reported to the Inland Revenue to ensure that there will be no unexpected tax liability in the coming year.

In terms of the way that payments are normally dealt with under a settlement agreement, the general rules are normally (although not always) followed:

• Paid free of tax: Ex-gratia payments and statutory redundancy payments
• Tax and national insurance to be paid: payments in lieu of notice, holiday pay, and normal contractual pay will be subject to tax and national insurance even when they are paid via a Settlement Agreement (and, if such is being paid, sums in respect of commission, bonus, equity schemes etc.)

You can use this Government calculator to work out what statutory redundancy payment you should receive.

Do I have to pay tax on ex-gratia payments which are over £30,000

As above, the first £30,000 of an ex gratia payment will be tax-free. Once you exceed the £30,000 tax-free limit you will then pay tax (but not national insurance) on any surplus.

For example, if your employer was offering you £50,000 as compensation for the termination of your employment then normally the following would apply:

• The first £30,000 of the payment would be free of tax and national insurance; and
• The remaining £20,000 would be subject to tax but not national insurance

Ex-gratia payments and Payments In Lieu Of Notice (“PILON”)

Until April 2018 it was possible to structure your settlement agreement so that you received your payment in lieu of notice tax-free. However, on 6 April 2018 new legislation was brought into force that now stops this from happening – employers must now account to HMRC for any payment made to an employee in respect of notice pay, so tax and national insurance deductions must be made.

Pensions and tax efficiency

Paying sums into an employee’s pension scheme upon termination can be useful if the employee has used up the £30,000 tax-free amount for ex-gratia payments, as they can potentially pay any surplus into their pension scheme tax-free – for example, if an employee is receiving compensation for loss of employment (an “ex gratia payment”) of £40,000, then they could potentially receive the first £30,000 tax-free under section 403 ITEPA 2003, and they could potentially pay the remaining amount into their pension scheme under section 408 ITEPA 2003. However, this will depend on the circumstances and you should check your pension situation with your solicitor and accountant first, before making any decision about this.

Ex-gratia redundancy payments

Statutory and enhanced redundancy payments fall within sections 401 to 416 of ITEPA 2003, and can therefore be paid tax-free (up to a maximum of £30,000) – provided they are paid genuinely on account of redundancy.

There is no normally no legal obligation for employers to pay enhanced redundancy payment (see this article for an analysis of when an employee may be legally entitled to an enhanced redundancy payment) but such payments are normally made as a gesture of goodwill, to avoid legal action, and to ensure that the employment relationship is terminated as quickly as possible. For example, in a redundancy situation it might take your employer over a month to go through the formal redundancy process (whereupon you may be made redundant anyway), so most employers take the view that it’s worthwhile to pay the employee a months’ ex-gratia pay to save them the time and effort of the process. If your employer wants to offer you an enhanced redundancy payment then they will normally do so through a redundancy settlement agreement.

Compensation for discrimination

If you have been discriminated against in the workplace then you may receive compensation for “injury to feelings” (i.e. the harm and upset you have suffered as a result of the distress you’ve suffered because of the discrimination). This normally, but not always, interlinks with a psychological injury that may have been sustained by the victim of the discrimination (for example, they may suffer from ‘stress and anxiety’ or depression, as a result).

So, can compensation for injury to feelings be paid tax-free? The answer is, as it is so often: “it depends”.

The general rule at the moment is: if an ex-gratia payment is made to an employee that  payment relates to injury to feelings and the discrimination giving rise to the payment is not related to the termination of employment, it can be paid tax free; if it relates to the termination of employment then it may be classed as a ‘termination payment’ and therefore subject to tax.

As an extra layer of complication, in the Finance Act 2018 the Government introduced another category of tax-free employment-related payments: a “disability exemption” payment. A payment on account of an injury or disability is tax free under section 406 of ITEPA 2003 and free of NICs. However, you will need to prove that, as an objective fact, you have a relevant disability and, further, that the person making the payment is making it on account of your disability (and not because of the termination of your employment). The “disability exemption” payment has, in our experience, not been much-used thus far, but we can explore with you whether we can use such an exemption in your particular circumstances.

Redundancy payments and ex gratia payments to employees

In redundancy situations you can receive the following sums as an ex-gratia payment:

1. Statutory redundancy pay; and
2. Any lump sum compensation payment paid, subject to the £30,000 tax-free limit

To be clear, the £30,000 limit includes both an lump sum ex-gratia payment made and any statutory redundancy paid, so if the total of these sums comes to over £30,000 then only the first £30,000 is tax free.

There is generally no obligation for employers to pay a lump-sum ex gratia payment to an employee (such payments are also known as an “enhanced redundancy payment”), but it is quite common for employers to do so in order to encourage a swift, efficient and amicable end to a redundancy process. The advantages to employers of offering an enhanced redundancy payment are as follows:

• It reduces the amount of time that the employer has to spend dealing with a redundancy consultation process;
• It means that the employer can, generally, finalize the entire redundancy process more quickly and therefore implement its new structure with a minimum of fuss;
• It limits the employer’s liability and ensures that it won’t get sued by employees for unfair dismissal

Employers normally offer enhanced redundancy payments to employees with more than two years’ continuous employment, but we have dealt with a lot of situations where employees with less than two years’ continuous employment are offered an ex gratia payment (so if you fall into this bracket then you might still receive some tax-free money as compensation for the termination of your employment).

Sometimes, however, you may have a legal right to an enhanced redundancy payment (if, for example, there is an express contractual right to receive such a payment). We have written an article on when you may be legally entitled to an enhanced redundancy payment here.

Please note, however: you can’t arrange for your notice pay to be paid ex gratia (or tax-free), and HMRC rules mean that you won’t be able to, for example, shorten your notice period and increase the ex gratia payment by a similar amount.

Tax indemnity clauses in settlement agreements

There may be a clause in your settlement agreement which is named a ‘tax indemnity clause’. Some of our clients become concerned about this clause, as they think it opens the door to potential tax issues in the future; this is particularly the case because, in a lot of situations, the relationship of trust and confidence between employer and employee has broken down and, frankly, the employee just wants to see the back of the employer.

Our general advice on these clauses is that there is normally nothing to worry about: they are standard clauses in settlement agreements and are used as a matter of custom and practice. Our experience is, further, that in the vast majority of cases there are no further tax issues once the employment has terminated and the settlement agreement has been completed.

We do recognise, however, that clients want to discuss such clauses and receive advice on them – we are, of course, more than happy to do that with all clients.

Disputes over whether a payment should be tax-free or not

Disputes do sometimes arise with HMRC as to whether a payment made to you as compensation for termination of employment is in fact a genuine ex gratia payment to an employee or not. If this happens then you should seek specialist tax advice on your situation in order to explore whether HMRC is dealing with your situation correctly or not.

Can our settlement agreement solicitors help?

Take a look at our settlement agreements guide: we can help you and often your employer will pay the fee. We have advised thousands of clients on settlement agreements and ex gratia payments to employees, so we’re well-placed to help you if you need some help with negotiating your ex gratia payment or, simply, a review of your agreement and signing it off.

Further reading: Settlement agreement advice for employees – common questions asked