Settlement agreement tax

The compensation payments the amount the employer pays the employee for loss of office or loss of employment. Where the parties enter into a settlement agreement the employer pays this extra, or ex-gratia, payment in return for the employee’s undertaking not to sue the employer.

The compensation payment is taxed subject to an exemption on the first £30,000. Another way to consider this, is that the first £30,000 of the compensation payment can be made without deduction of tax.

However, if when the employer terminates employees it routinely pays a compensation payment (of the sort ‘two weeks’ salary for each year worked’), then the compensation payment may be taxed in full.

The £30,000 exemption will cover not only compensation payments, but statutory and enhanced redundancy payments.

If the business fails to provide the employee with notice of termination of employment, it will liable to the employee.

Some businesses have employment terms and conditions which enable them to pay the employee instead of providing full notice. This is a pay in lieu of notice clause (abbreviated to PILON) and it renders the payment in lieu of notice taxable.

If there is no PILON clause in the employment contract and the employer, as a matter of ‘custom and practice’, terminates the employment of its employees without notice and pays in lieu of that notice, then the payment is taxed.

The settlement agreement may contain post termination restrictions prohibiting the employee from competing or dealing with the employer’s clients and suppliers.

To give effect to these restrictive covenants the employer has to make a payment against the employee’s undertaking, and in the settlement agreement this is expressed as being taxable.

If the business needs to downsize or cut costs it will be obliged to pay relevant employees a statutory redundancy payment. The payment is not taxable.

Some employers make an enhanced redundancy payment, also referred to as a contractual redundancy payment. If there is no question that the termination is on grounds of redundancy, then this is payable tax free.

Salary and benefits are employment earnings, and for the period up·to the date of termination they are subject to income tax in the usual way. Holiday leave accrued and not taken at the date of termination, is paid in lieu by the employer and is also taxed.

The final arbiter in matters of tax is HM Revenue and Customs (HMRC).

Employers will always refrain from guaranteeing the tax status of the settlement package. It is possible that HMRC will audit the employer’s deductions of tax, and assess that more tax is due and request payment. To ward against this the employer will ensure that the employee is liable for any additional tax – the employer includes a tax indemnity in the settlement agreement such that the employee reimburses the employer for additional tax paid to HMRC.