Is a settlement agreement tax-free?
In this article one of our specialist employment solicitors, Chris Hadrill, answers the question of whether a settlement agreement is tax-free.
If you’re reading this article then you’re probably an employee who has been offered a settlement agreement or, alternatively, you expect to be offered a settlement agreement. One of the principal advantages of a settlement agreement is that, in certain circumstances, the payments made under the agreement can be paid tax-free up to a maximum of £30,000 – this tax exemption makes settlement agreements attractive to departing employees and encourage settlement rather than litigation.
We’ll explore the following in this article:
- What sums under a settlement agreement are taxable?
- What sums can you expect to receive under a settlement agreement tax-free?
- Examples of where sums can be paid tax-free under a settlement agreement
- HMRC guidance on tax on settlement agreements
- What you should do if you have been offered a settlement agreement
What sums under a settlement agreement are not tax-free?
How much of the payments under a settlement agreement are taxable will depend on the nature and amount of the payments.
‘General earnings’ will normally be subject to tax (and, where applicable, national earnings) under a settlement agreement. General earnings will normally (but not always) include (but are not limited to) the following types of payment:
- Any salary, wage or fee (salary, bonus, commission etc.)
- Any other kind of benefit (health insurance, life assurance, car allowance etc.)
- Employer-financed retirement benefits
- Payments in respect of share options and/or share awards
- Gardening leave payments
- Payments for restrictive covenants
- Contractual payments in lieu of notice
- Compensation for injury to feelings where discriminatory act took place after the termination of employment
What sums can you expect to receive under a settlement agreement tax-free?
The first £30,000 of payments that fall within section 401 of the Income Tax (Earnings and Pensions) Act 2003 can be paid tax-free under a settlement agreement, with the balance over £30,000 subject to tax but not employee National Insurance contributions (again, these are not exhaustive):
- Statutory redundancy pay;
- Sums paid as compensation for termination of employment;
- Ex-gratia payments;
- Compensation for injury to feelings where the relevant incident(s) take place before the termination of employment
Multiple payments made in respect of the same job (or different jobs with the same employer or associated employers) will be aggregated with respect to the £30,000 tax-free exemption.
The following sums can also be paid tax-free with no limit (depending on the circumstances):
- Contributions made into a registered pension scheme
- Payments on account of a disability or injury (but the payment must relate to the sustaining of the disability or injury)
- Legal cost contributions (although your employer will normally pay this direct to your solicitor upon completion of a settlement agreement)
- Outplacement payments (although your employer will normally pay this direct to the outplacement provider)
Sums paid of death or because of departure due to injury/disability can be paid tax-free without limit but great care needs to be taken with these payments, as whether they can be paid tax-free depends upon the technicalities of the situation. Equally, you should speak to your accountant or tax adviser about your pension payments (there are annual and lifetime allowances for pension scheme contributions and payments in excess of these allowances would incur a tax liability).
Examples of where sums can be paid tax-free under a settlement agreement
Please find below a list of circumstances where you can be paid sums under a settlement agreement tax-free (this list is not exhaustive):
- Where your employer terminates your employment but agrees to pay you a sum of money to compensate you for the termination of your employment;
- Where you are discriminated against, harassed or victimised during your employment, leading to a claim for discrimination (or harassment or victimisation);
- Where a sum of money is paid to you as an enhanced redundancy payment
Please note that the £30,000 tax-free upper limit applies in respect of all of the above examples.
HMRC guidance on tax on settlement agreements
If you have been offered a settlement agreement by your employer (or are an employer offering a settlement agreement to an employee) and you are unsure as to what tax you should be paying on a settlement agreement then it is recommended that you obtain legal advice on your position – this is a reasonably complex area of law and getting it wrong can have potentially serious consequences. However, you may also follow the guidance provided by HMRC on tax on settlement agreements on determining the correct tax treatment of a termination payment – HMRC recommends that the following questions are addressed:
- Does the payment fall within the category of general earnings (or is it a benefit of the employment) under Parts 2 to 5 of the Income Tax (Earnings and Pensions) Act 2003 (“ITEPA 2003”)?
- If not, is it a payment for a restrictive covenant taxable under sections 225 and 226 of ITEPA 2003?
- If not, and no other income tax charge applies (for example, compensation for loss of a share option) ,is the payment a payment taxable under sections 401 to 416 ITEPA 2003?
What you should do if you have been offered a settlement agreement
If you have been offered a settlement agreement then it is recommended that you do the following:
- Obtain details of what you are being offered in writing;
- Categorise the payments that you are receiving as best as you are able (in order to evaluate whether any sums you are receiving can be paid tax-free and, if so, how much);
- Consult a settlement agreement solicitor to obtain legal advice on the settlement agreement