| In short: Part of a settlement agreement is usually tax-free and part is usually taxable. The first £30,000 of a genuine termination payment for loss of your job is usually free of income tax and National Insurance under section 403 ITEPA 2003. Salary, holiday pay, bonuses, pay in lieu of notice, and payments for restrictive covenants or undertakings are all taxable in full as earnings — and do not benefit from the £30,000 exemption. If notice is not fully served or paid in lieu, then part of termination payment equal to the value of unpaid notice is usually taxable as post-employment notice pay. |
If you have been offered a settlement agreement, one of the most important — and most misunderstood — questions is how the payments will be taxed. Getting it wrong can be costly. This guide explains the rules in the order HMRC applies them, so you know what to expect before you sign. For the wider picture, see our main settlement agreement guide.
Settlement Agreement Tax at a Glance
The table below summarises how each common element of a settlement agreement is taxed, with the statutory basis for each.
| Payment | Tax treatment | Statutory basis |
| Salary, holiday pay, contractual bonus | Taxable in full as earnings | s.62 ITEPA 2003 |
| Pay in lieu of notice (or the Post Employment Notice Pay (‘PENP’) slice) | Taxable in full as earnings — no £30,000 relief | ss.402B & 402D ITEPA 2003 |
| Payment for restrictive covenants / restrictive undertakings | Taxable in full as earnings — no £30,000 relief | s.225 ITEPA 2003 |
| Payment in anticipation of retirement | Taxable — no £30,000 relief | s.393-394 ITEPA 2003 |
| Genuine ex-gratia / compensation for loss of employment | First £30,000 tax-free; balance taxable | ss.401–403 ITEPA 2003 |
| Statutory redundancy pay | Counts towards the £30,000, but within it is tax-free | s.309 / s.403 ITEPA 2003 |
| Employer contribution to your legal fees | Tax-free subject to condition, e.g. it must be paid directly to your legal adviser under the agreement | s.413A ITEPA 2003 |
| Outplacement / retraining | Tax-free and outside the £30,000 subject to conditions | ss.310–311 ITEPA 2003 |
| Personal injury (including recognised psychiatric injury) | Tax-free and outside the £30,000 | s.406 ITEPA 2003 |
| Employer pension contribution | Can be tax-free, subject to allowances | s.408 ITEPA 2003 |
How HMRC Decides What Is Taxable
HMRC applies a strict order of priority when deciding how each part of a settlement payment is taxed. Understanding that order shows why the label you give a payment matters far less than its legal substance. The order of analysis is:
- Is it earnings? If the payment is earnings under section 62 ITEPA 2003 — salary, accrued holiday pay, a contractual bonus — it is taxable in full through payroll.
- Is it for a restrictive undertaking? If not earnings, is it a payment for a restrictive undertaking under section 225 ITEPA 2003? If so, it is taxable in full as earnings. Section 225 takes priority over the £30,000 exemption.
- Is it a retirement payment? If not, is it made on or in anticipation of retirement under section 393-394 ITEPA 2003? If so, it does not benefit from the £30,000 exemption.
- Only then: the termination regime. Only if none of the above apply does the payment fall within sections 401–403 ITEPA 2003, where the £30,000 exemption may be available.
A payment does not become tax-free simply because the agreement calls it “compensation” or “ex-gratia”. HMRC looks at the true character of each sum.
The £30,000 Tax-Free Threshold
Under section 403 ITEPA 2003, the first £30,000 of a genuine termination payment, including a redundancy payment, can usually be paid free of income tax and National Insurance. The exemption applies to compensation for the loss of your employment — not to payments for work you have already done or services you have already provided. If your total qualifying termination payment is £30,000 or less, you should normally receive it free of tax. Anything above £30,000 is subject to income tax (though not employee National Insurance) in the usual way. Importantly, if any of the termination payment is Post Employment Notice Pay (‘PENP’) that part will be subject to deductions for income tax and national insurance.
Is Pay in Lieu of Notice (PILON) Taxable?
Yes. Since 6 April 2018, all pay in lieu of notice is taxable in full — regardless of whether your contract contains a PILON clause. Previously, where there was no contractual right to make a PILON, it could sometimes fall within the £30,000 exemption. That distinction no longer exists. The amount of your termination payment that represents unworked notice /unpaid notice entitlement is usually deemed Post-Employment Notice Pay (PENP). PENP is treated as earnings under section 402B ITEPA 2003, taxed in full, and cannot benefit from the £30,000 exemption. If you are leaving without working your full notice or without being paid in lieu of your notice, PENP will almost always apply. When calculating PENP the relevant notice period is the notice the employer is required to serve under the employment contract.
How PENP Is Calculated
PENP is worked out using a statutory formula set out in section 402D ITEPA 2003:
PENP = ((BP × D) ÷ P) − T
Where:
- BP — your basic pay in the last pay period ending before the “trigger date” (usually the date notice is given, or the termination date if no notice is given). Basic pay is calculated before any salary sacrifice, and excludes overtime, bonus, commission and most allowances.
- D — the number of calendar days in your unworked notice period, by reference to the greater of your contractual or statutory notice.
- P — the number of calendar days in the relevant pay period.
- T — any taxable termination payment already made that relates to the notice period (typically a contractual PILON already taxed through payroll). Statutory redundancy pay is excluded.
If the formula produces a negative figure, PENP is nil.
Important update: since 6 April 2021, a mandatory alternative calculation applies where your basic pay is paid in equal monthly instalments but your notice period is not a whole number of months. In that case the figure 30.42 (365 ÷ 12) is substituted for P. The simplified “whole-month” approach above only works neatly where notice is expressed in whole months.
Tax on Restrictive Covenants and Confidentiality Clauses
This is one of the most misunderstood and most dangerous areas of settlement agreement taxation. Many people assume that everything except notice pay falls within the £30,000 exemption. That assumption can be wrong wherever the agreement places a new restriction on your conduct — known as a restrictive undertaking.
The Section 225 Charge
Section 225 ITEPA 2003 provides that where you give a “restrictive undertaking” in connection with your employment and a payment is made in respect of it, that payment is treated as earnings and taxed in full, with no access to the £30,000 threshold. Section 225(8) defines a restrictive undertaking broadly as one “which restricts the individual’s conduct or activities”. Because section 401(3) provides that the termination regime does not apply to sums already chargeable under another provision, section 225 takes complete priority where it applies.
Mrs A v HMRC [2022] UKFTT 421 (TC)
The reach of section 225 was confirmed in the First-tier Tax Tribunal decision of Mrs A v HMRC [2022] UKFTT 421 (TC), where a payment of over £1 million made under a settlement agreement was held to be taxable in full under section 225. The Tribunal confirmed that the following routine settlement terms can each amount to a restrictive undertaking:
- An obligation to keep the fact and terms of the settlement confidential
- A non-disparagement or non-derogatory statements clause
- Post-termination non-compete or non-solicitation covenants
For guidance on confidentiality issues our page on confidentiality in settlement agreements explains how these clauses work in practice.
Payments Made in Anticipation of Retirement
Under section 393-394 ITEPA 2003, a payment made on or in anticipation of an employee’s retirement is treated as a “relevant benefit” under an employer-financed retirement benefits scheme and is taxed under that provision rather than the termination regime. The result is that it does not benefit from the £30,000 exemption at all. Whether a payment is “in anticipation of retirement” is a question of fact, so this risk is most acute for employees at or near retirement age.
Outplacement and Retraining
Where your employer provides or pays for outplacement counselling that meets the conditions in section 310 ITEPA 2003 (broadly: services to help you find new work, where you have at least two years’ service and the support is offered generally), the cost is entirely tax-free and outside the £30,000 threshold. It does not reduce the amount of other payments that can be paid tax-free. Section 310 operates as an exemption, not a deduction — it does not let you claim relief for outplacement you arrange and pay for yourself. Retraining courses meeting the conditions in section 311 ITEPA 2003 are treated in the same way.
Injury to Feelings and Personal Injury Payments
Payments for personal injury, including a recognised psychiatric injury, are generally exempt under section 406 ITEPA 2003 and do not count towards the £30,000 limit.
Compensation for injury to feelings for discrimination not related to termination is generally speaking not treated as earnings or a termination payment, and will not usually be taxable. Amounts attributed to injury to feelings should be proportionate to the Vento guidelines, and substantial awards may be challenged if they are not.
Compensation for injury to feelings for discrimination related to termination is treated differently, being treated as a termination payment and taxable unless it falls under the £30,000 threshold. See HMRC Guide EIM12965
Your Employer’s Contribution to Legal Fees
Most settlement agreements include a contribution from your employer towards your legal costs of taking advice on the agreement. Where that contribution is paid directly to your adviser and the agreement specifically provides for it, it is exempt under section 413A ITEPA 2003 and is not taxed as a benefit in your hands. Our cost promise explains how this typically works.
Paying Part of Your Settlement Into a Pension
Where a termination payment is going to exceed £30,000, directing part of the excess into your pension by means of a sacrifice may be a legitimate and tax-efficient step — an employer pension contribution can fall outside the threshold under section 408 ITEPA 2003, subject to the usual pension allowance limits. If you are thinking about this it is advisable to seek specialist tax and financial advice. One potential trap to avoid: if you are thinking of a sacrifice of a PILON into a pension to save tax, while possible it will probably not save you any tax. This is because of the PENP calculation, which will result in a PENP charge on the termination payment.
Frequently Asked Questions
Is a settlement agreement payment tax-free?
Partly, usually. The first £30,000 of a genuine payment compensating you for the loss of your job is usually tax-free under section 403 ITEPA 2003. Salary, holiday pay, bonuses, pay in lieu of notice and payments for restrictive covenants are taxable in full and do not count towards that £30,000.
How much of a settlement agreement is tax-free?
Up to £30,000 of the genuine compensation (ex-gratia) element is free of income tax and National Insurance. The £30,000 figure is a total allowance across all qualifying termination payments, not a separate allowance for each payment.
Is payment in lieu of notice taxed?
Yes. Since 6 April 2018, all pay in lieu of notice is taxable in full as earnings, as a contractual PILON or as Post-Employment Notice Pay (PENP) under sections 402B and 402D ITEPA 2003.
What is PENP?
Post-Employment Notice Pay is any part of a termination payment that represents the basic pay you would have received for any notice period your employer is required to give under your employment contract that you do not work or are not paid in lieu. It is taxed as earnings and is calculated by a statutory formula: PENP = ((BP × D) ÷ P) − T.
Do I pay tax on money for signing a confidentiality or non-compete clause?
Potentially yes. A payment attributed to a restrictive undertaking — including confidentiality, non-disparagement, or an agreement not to pursue claims — is taxable in full under section 225 ITEPA 2003, with no £30,000 relief, as confirmed in Mrs A v HMRC [2022] UKFTT 421 (TC).
Is statutory redundancy pay tax-free?
Statutory redundancy pay counts towards the £30,000 threshold, and is tax-free.
Is my employer’s contribution to my legal fees for settlement agreement advice taxable?
No, provided it is incurred exclusively in connection with the termination of the employee’s employment, is paid directly to your adviser and the agreement specifically provides for payment by the employer. It is then exempt under section 413A ITEPA 2003.
Can I pay part of my settlement into my pension to save tax?
Often yes for genuine compensation above £30,000, where an employer pension contribution can fall outside the threshold under section 408 ITEPA 2003, subject to pension allowances and regulated financial advice.
Key Points to Remember
- HMRC applies a hierarchy: earnings first, then section 225, then section 393-394, and only then the £30,000 termination regime.
- Salary, holiday pay, bonuses and pay in lieu of notice are always taxable as earnings.
- The first £30,000 of a genuine termination payment is normally tax-free under section 403 ITEPA 2003.
- PENP is the mechanism that taxes unworked notice entitlement or notice entitlement not paid in lieu. This can result in some of a termination payment being subject to tax and national insurance deductions, as PENP.
- Payments for restrictive covenants and undertakings, such as new confidentiality obligations, are fully taxable under section 225, with no £30,000 relief.
- Outplacement (s.310), legal-fee contributions paid to your adviser (s.413A) and personal injury (s.406) are tax-free and outside the £30,000 subject to conditions being met.
- Always take independent legal advice, and consider specialist tax and independent financial advice, especially where the figures are large and/or the structure is complex.
Primary sources
Legislation: section 402D ITEPA 2003 (legislation.gov.uk) • HMRC guidance: PENP formula, Employment Income Manual EIM13880 (gov.uk)
Legal Disclaimer
The contents of this article are intended to be for general information and purposes only and do not amount to (nor are they intended to be) legal, tax or financial advice or a complete or authoritative statement of the law nor should they be treated as such. No warranty or promise is given, express or implied, as to accuracy of the information on this page and no liability is accepted for any error or omission. You should instruct a specialist employment solicitor to advise you on your particular situation and not act or rely on the information on this page.
