This guide (and the Table below) will you help to quickly identify the tax implications for each type of payments commonly made under a settlement agreement.
Contents
Who pays the tax?
Where a payment isn’t exempt from tax the employer is required to make the appropriate deductions for income tax and national insurance contributions (‘PAYE Deductions’). The employee should then receive the net sum.
But sometimes employers fail to make the appropriate PAYE Deductions. While some employees may think this is an ’employer’s problem’ delve a little deeper into the typical settlement agreement wording you will find that’s not the case. Usually settlement agreements are drafted to make the employee ultimately liable for any extra tax and any additional interest charges, finee or penaltiesthe Revenue (‘HMRC’) imposes.
Tax Indemnity
This kind of settlement agreement clause is called a tax indemnity and is pretty standard.
Therefore, it is important to get the tax position right in the settlement agreement, not just to ensure everything is above board but for the employee’s peace of mind there won’t be a nasty bill to pay sometime later when the mistake is picked up by the employer or their tax advisers or HMRC.
Common tax mistakes by Employers
- Wrongly bundling a taxable payment, such as holiday pay or a bonus, with a tax free termination payment (resulting in a failure to make PAYE Deductions on the holiday pay and bonus);
- Wrongly including notice pay (either a payment in lieu of notice (‘PILON’) or post-employment notice pay (‘PENP’)) into a termination payment and then paying it all free of tax when the PILON / PENP element should have been subject to PAYE Deductions.
- Requiring the employee to enter into new restrictive covenants / post-termination restrictions but not assigning a specific sum in exchange. This runs the risk of some or possibly all of the payments expressed as tax-free becoming taxable.
We therefore recommend you ensure you discuss the tax implications with a solicitor and they are aware of all of your outstanding contractual entitlements to pay, holidays and bonuses and any other taxable entitlements, so these are dealt with separately to the termination payment in the settlement agreement.
TABLE: Tax Implications for each type of Settlement Agreement payment
| Payment | Tax-free? | Notes | References |
|---|---|---|---|
| Wages accrued during employment | No | – | |
| Holiday pay | No | – | |
| Contractual bonus | No | – | |
| Notice Pay / Payment in lieu of notice (‘PILON’) / Post Employment Notice Pay (‘PENP’) | No | – | |
| Statutory Redundancy Payment | Yes | – There is a statutory formula to calculate this. The maximum for 2023 is £19,290. | |
| Termination Payment (i.e. compensation for loss of employment) | Yes – subject to limits (See Notes 1-3) | * (1) The tax-free slice only applies to the first £30,000 during an employment. This £30,000 allowance is inclusive of any redundancy payment. The balance over £30,000 is subject to income tax deductions but not employee national insurance contributions. As the employer will still need to make Class 1 employer contributions on the balance over £30,000, the payment must be made via the payroll. (2) Tax-free status assumes the employee has fully worked or been paid their notice entitlement with PAYE Deductions, there will be no PENP usually. (3) If there is PENP this will result in PAYE needing to be deducted from the Termination Payment. What is PENP? | Section 401 of the Income Tax (Earnings and Pensions) Act (ITEPA) 2003. Section 403 of ITEPA specifies the value (£) of this threshold. |
| Ex-gratia payment or severance payment (these are usually different ways of describing a termination payment) | See above | See above | |
| Payment made on retirement (cash) | No, usually (See Note 4) | (4) – this relates to a cash payment to the below. Sometimes there may be uncertainty as to whether the payment is being made in a redundancy situation or because of retirement. | |
| Payment of additional contributions into the employee’s pension | Yes (conditions apply) | The payment must be made into a registered, qualifying or tax-exempt pension scheme. If there is an arrangement where part of termination payment or (usually all or part of the balance over the £30,000 tax-free slice, or the PILON) is waived in exchange for special additional contribution into the employee’s pension, the payment should not be subject to PAYE Deductions. | Section 408 ITEPA 2003 EIM13735 |
| Payment made on termination because of the death, disability or injury of an employee | Yes | (5) There is no limit on the value of the tax-free treatment of this type of payment. (6) There must be a medically recognised disability or injury which prevents the employee from doing their job. Tax-free treatment is only available where the payment is wholly on account of that disability or injury. (7) If these payments are part of a settlement agreement it is likely some of the payment(s) will be in exchange for settling potential claims such as unfair dismissal and therefore not qualify as a tax-free disability payment because they are not wholly on account of disability. (8) Where substantial sums are involved it may be sensible to seek clearance from HMRC on the tax treatment of payments for disability or injury. | Section 406(b) ITEPA 2003 EIM13635 EIM13637 EIM13640 EIM13650 |
| Personal Injury compensation | Yes (conditions apply) | There must be a medically recognised injury and the level of payment must be consistent with recognised levels of award for the particular injury. | |
| Injury to feelings (caused by discrimination before termination) | Yes (conditions apply) | The amount of compensation permitted to be paid tax-free must be reasonable by reference to level of hurt feelings due to discrimination as set out in case law and presidential guidance. On March 2023 the President of the Employment Tribunals of England and Wales updated the injury to feelings bands for claims presented on or after 6 April 2023 as follows: (a) a lower band of £1,100 to £11,200 (less serious cases); (b) a middle band of £11,200 to £33,700 (cases that do not merit an award in the upper band); and (c) an upper band of £33,700 to £56,200 (the most serious cases), with the most exceptional cases capable of exceeding £56,200. | Presidential Guidance issued on injury to feelings awards by date: 24.03.23 05.09.17 |
| Legal Fees Payment (i.e. toward employee’s legal fees in relation to a settlement agreement) | Yes (conditions apply) | This applies to legal costs only, and not other professional fees, such as accountancy or financial advice. A payment towards legal fees is only exempt from tax if it is made under specific term in the settlement agreement, the payment is made direct to the employee’s solicitor (as opposed to the employee) and the costs have been incurred by the employee solely in connection with the termination of the employee’s employment. | Section 413A ITEPA 2003 EIM13740 |
| Payment for Outplacement / Career Support Payment | Yes (conditions apply) | To qualify as exempt from tax (1) the employee must have been continuously employed for two years (2) the nature of the outplacement service must only involve giving advice, guidance, imparting or improving skills and the making available the use of office equipment or similar facilities (3) the purpose must be to help the employee to adjust to their employment ending and/or to find other gainful employment (including self-employment) and (4) the outplacement service needs to be generally available to employees or former employees of the employer or classes of employee. Outplacement benefits are more common in redundancy situations. | Section 310 ITEPA 2003 EIM13745 |
| New restrictions such as restrictive covenants or post-termination restrictions | No | In some settlement agreements an employer includes clauses requiring the employee to agree to new post-termination restrictions, for example, preventing the employee from solicitor or dealings with customers. The consideration the employer pays the employee in exchange for the employee agreeing to these new restrictions is subject to income tax deductions. |
The contents of this page are for guidance only and do not constitute legal or other advice. You should consult a solicitor for advice on your settlement agreement and the tax implications.
