Is a settlement agreement tax-free?

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:

  1. What sums under a settlement agreement are taxable?

  2. What sums can you expect to receive under a settlement agreement tax-free?

  3. Examples of where sums can be paid tax-free under a settlement agreement

  4. HMRC guidance on tax on settlement agreements

  5. What you should do if you have been offered a settlement agreement

What payments under a settlement agreement are normally subject to tax?

How much of the payments under settlement agreements (or compromise agreements, as they used to be called) are taxable will depend on the nature and amount of the payment.

‘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.)

  • Holiday pay

  • Employer-financed retirement benefits

  • Payments in respect of share options and/or share awards

  • Gardening leave payments

  • Payments for restrictive covenants

  • A contractual payment in lieu of notice

  • Compensation for injury to feelings where discriminatory act took place after the termination of employment or where it is connected to termination of employment

  • Termination payments which are set out in the contract of employment

It is a good idea to always check your employment contract to double-check what payments you can expect to receive contractually, and therefore what should be taxable (and what should not).

With a payment in lieu of notice, there are complicated calculations relating to post employment notice pay – you should seek advice on this from a specialist accountant or tax adviser.

What sums can you expect to receive under a settlement agreement tax-free?

The first £30,000 of termination payments that fall within section 401 of the Income Tax (Earnings and Pensions) Act 2003 can be paid free of tax under a settlement agreement, with the balance over £30,000 subject to tax but not employee National Insurance contributions (again, these are not exhaustive):

  1. Statutory redundancy pay;

  2. Sums paid as compensation for termination of employment;

  3. Ex-gratia payments ;

  4. 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. For example, if the sum paid as compensation for termination of your employment exceeds £30,000 then any statutory redundancy payment made to you will also be subject to tax.

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 on 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), as well as discuss it with your instructed solicitors.

If you have a query as to what settlement payments can be paid tax-free or subject to tax then the best people to ask will normally be, firstly, those within the payroll or human resources function at your workplace. You can also ask your employment solicitor (who commonly advice on the taxation of a settlement payment) or call HMRC to ask for guidance.

Read our guide to settlement agreements here

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):

  1. Where your employer terminates your employment but agrees to pay you a sum of money to compensate you for the termination of your employment (also known as an ex gratia payment)

  2. Where you are discriminated against, harassed or victimised during your employment, leading to a claim for discrimination (or harassment or victimisation);

  3. Where a sum of money is paid to you as an enhanced redundancy payment (although contractual redundancy payments are, as detailed above, normally subject to tax and national insurance in the normal way); and

  4. Statutory redundancy payments

These sums are generally referred to as “compensation for termination of employment”, “compensation”, or an “ex gratia payment”.

Please note that the £30,000 tax-free upper limit applies in respect of all of the above examples.

How much tax can you expect to pay overall under a settlement agreement?

This will entirely depend on your situation, and it is recommended that you speak to your instructed legal adviser, your employer’s payroll/human resources team, and/or HMRC to be able to understand what amount of tax you are likely to pay under your settlement agreement.

It is recommended that, once the compensation payment under your settlement agreement is made to you, you should obtain from your (former) employer a copy of your final payslip (so you can check whether you have been paid all the sums that you should have been paid, and to check how these have been taxed). You should also carefully consider what tax year you wish for your settlement agreement payments to be made in, as this may affect the overall tax you will pay on your settlement agreement payment.

Are the settlement agreement payments made to me UK taxable, or should they be taxed in another jurisdiction?

How sums paid under settlement agreements should be taxed, and in which jurisdiction, depends on a number of variables including (but not limited to) your personal circumstances, which countries you are a citizen of, and where you have been working during the course of your employment.

Is there a difference between the tax I can expect to pay on a compromise agreement and under a settlement agreement?

No, there is no difference between a compromise agreement or a settlement agreement – they are the same thing, and sums will be (or should be) taxed the same way under a settlement agreement or a compromise agreement.

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 as to what the tax implications on payments under a settlement agreement are 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:

  1. 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”)?

  2. If not, is it a payment for a restrictive covenant taxable under sections 225 and 226 of ITEPA 2003?

  3. 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?

If you are unsure as to what tax on settlement agreement you should be paying then it is recommended that you speak to your employer to obtain an understanding of your settlement agreement tax implications.

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:

  1. Obtain details of what you are being offered in writing;

  2. 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);

  3. Consult a settlement agreement solicitor to obtain legal advice on the settlement agreement

Redmans can provide you with advice on your settlement agreement – if you’d like to discuss your settlement agreement with this please call us on 0203 397 3603 , email us , or ask for a call back