What tax do I pay on a settlement agreement?

You’ve got the settlement offer but you’re confused as about which payments are tax-free. What happens if your employer gets the tax wrong? Will you have to pay the employer back? Worse still, will you have to pick up HMRC fines and penalties. This is ‘Ultimate Guide’ to tax issues in settlement agreements’ answers all your questions.

Written by a leading employment law solicitor.

Quick summary

• A redundancy or termination payment up to £30,000 can usually be paid tax-free.
• wages, holiday pay, contractual bonuses need to have income tax and employee national insurance contributions deducted (PAYE Deductions).
• A payment in lieu of notice should be paid less PAYE Deductions, usually.
• If the employee is not paid in lieu of their full notice or they have not worked and been paid for their full notice entitlement, the some or possibly all of the termination payment may be taxable. This is known as Post-Employment Notice Pay.
• Usually a settlement agreement has a clause that makes the employee liable to pay the employer any excess tax due on the payments, over and above any tax deducted.
• This means employees should ensure they get proper advice on the tax implications on their settlement agreement.
• There are other payments that may be made tax-free, including an employer payment for career counselling (outplacement) or legal advice on the settlement agreement. You can learn
• Payments to an employee that is retiring and/or for injury to to feeling may be subject to tax, depending on the circumstances.
• Payments in relation to an employee agreeing to new non-compete restrictions are taxable.

Detailed Guidance

As a general rule, a termination payment up to £30,000 is tax-free. This tax-free slice is inclusive of any redundancy payment. Care should be taken to ensure that other types of taxable payments, such as holiday pay, are not wrongly rolled into a termination payment. Similarly, if there is notice pay has not be paid and taxed, this may result in a tax charge on some or possibly all of the the first £30,000.

Most other payments, with a few exceptions, will be subject to PAYE deductions, i.e. income tax and employee national insurance.

who pays the tax on a settlement agreement?

What qualifies as a tax-free ‘termination payment?

You may see a term called ‘Post Employment Notice Pay’, or PENP for short, used in a settlement agreement. PENP is subject to the usual PAYE deductions.

If tax is due will my employer deduct it from the settlement?

If some or all of the payments are taxable, usually, the employer should deduct the appropriate income tax and any applicable employee national insurance, before making the payment. If the settlement agreement wrongly provides for a payment to be paid tax-free, and the tax authority (HMRC) discover this later, the employer will be asked to make good the situation by paying the tax and national insurance due, along with interest and possibly fines and/or penalities. While good employers will try and make sure the correct tax is deducted, and get it right most of the time, mistakes can happen. To protect themselves, employers usually include a clause in the settlement agreement that says the employee will pay the employer a sum equal to any excess tax and associated interest and/or fines or penalties HMRC demands from the employer.

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