Settlement Agreements and Tax

Paul Kelly, partner at Blacks Solicitors answers…

The law says that an individual is allowed a tax free sum of up to £30,000 as compensation for loss of employment and this can be made via a settlement agreement. However, the different components that make up the final settlement payment mean that some of them can’t be paid tax free.

Non-taxable payments (up to £30,000)

  • Ex gratia payments as compensation for loss of employment.
  • Statutory redundancy payments.
  • Damages and payments for unfair dismissal.  

Taxable payments include:

  • Payments in lieu of notice (PILON) are taxable however there must be a clause in the original employment contract (or perhaps an employee handbook) allowing such payments. If not, payments in lieu may still be taxed if it is the usual custom and practice of the employer.
  • Payments to enforce post-termination restrictions and confidentially requirements. These are generally terms to ensure the individual does not solicit business from their former employer and/or maintains confidentiality of the business after employment.
  • Any holiday payments made in lieu.
  • Any salary or benefits.

Tax Indemnity

Despite the law telling us that up to £30,000 can be paid free of tax, companies still seek the comfort of requiring the employee to provide an indemnity in a settlement agreement. This means that if HMRC looked at the agreement at some point in the future and decided that some tax should have been paid on the £30,000 then the individual ultimately is liable. However, it is very rare for this to occur and should not happen if the compensation payment was in respect any of the items listed as non taxable above.

Answer given by Paul Kelly of Blacks Solicitors on 2 October 2013

Note: The above answer does not deal with the issue of whether payments for injury to feelings arising from discrimination or payments due to disability or injury. These may not be taxable but you should speak to your solicitor as the facts of your case will be very important in assessing the tax position.

IMPORTANT: The contents of this page are for guidance only and do not constitute legal advice. You should consult a solicitor without delay if you require legal advice on a particular employment matter.