If you are negotiating a settlement agreement with your employer, it will be important to understand the tax rules that apply to any payment you may receive.

Signing a settlement agreement

A settlement agreement is a legal agreement between an employee and an employer. Formerly referred to as a compromise agreement, a settlement agreement is usually agreed just before or after an employee’s contract has been terminated. They are often used in relation to redundancies but can be agreed in other circumstances such as disciplinary proceedings.

In most cases a settlement agreement is used to provide a 'clean break' between employee and employer. Depending on the specific terms of the agreement, the employee agrees to waive their rights to bring employment claims against the employer in return for a settlement figure. This figure may however be subject to tax and national insurance deductions.

What is the current position for paying tax on settlement agreement payouts?

Do I have to pay settlement agreement tax?

The answer is 'it depends'. The amount of settlement agreement tax you may or may not have to pay will be determined by a number of factors, including what the payment relates to and how it has been paid, which may result in tax liabilities for the employee.

Compensation

Employees can be paid up to £30,000 tax-free as compensation under a settlement agreement. This includes payments that are non-contractual and compensatory relating to loss of office or employment.

If the settlement exceeds the £30,000 exemption, you will in most cases be liable to pay tax.

Your employer will be responsible for deducting tax at the oT tax code, calculated on the basis that personal allowances are not included and the tax bands are to be divided into twelfths aligned to tax months. For the employer, this could mean making deductions at rates varying from 20% to 45%, depending on how much over the £30,000 threshold the payment is.

This is a complex calculation. If your settlement is looking to exceed the £30,000 level, take professional advice to understand the full tax implications and liabilities that will result.

Outstanding payments for salary, holiday and PILON

If you have any outstanding salary payments up to the date your settlement agreement states your contract ends, these will be taxed as normal, with the usual deductions for tax and national insurance.

Similarly, if you have any holiday payments owed up to the date your employment ends, these will also be subject to the usual tax deductions.

Employees are also taxed on any payment in lieu of notice (PILON). Since 2018, there is no longer a distinction between the tax owed on notice payments made to employees with a PILON clause in their employment contract. When this new rule was introduced, the government created a standard statutory formula that employers should apply to ensure any pay in lieu of notice is taxed correctly. The settlement agreement should state the amount of payment in lieu of notice you will receive.

Redundancy payments

The £30,000 tax-free amount is to include all redundancy payments, both statutory and contractual.

Injury to feelings payments

Payments for injury to feelings are only exempt from standard tax if they are related to a recognised medical condition or psychiatric injury and are the direct result of unlawful discrimination suffered by the employee prior to the termination of contract.

If an injury to feelings payment is connected to or a result of the termination of employment, the amount will be taxable.

Injury or disability payments

Payments made to employees for injury, disability or death may be tax-free if it can be shown the figure does not relate to any effect on the employee's earnings.

Confidentiality and restrictive covenants

Confidentiality clauses and restrictive covenants are used where the employer seeks to limit the employee's ability to contact clients or take up employment with a competitor business.

Where the employer wants to introduce a confidentiality clause or restrictive covenant within the settlement agreement, the employee must be paid a sum of money, known as 'consideration’, for the clause to be binding. Typically, this is a nominal fee, but will be taxable and subject to national insurance in the usual way.

Pension contributions

If you are receiving payments from an employer into a pension scheme, these should be considered separately and not included in the £30,000 exemption.

Foreign service relief

Settlement agreement compensation paid to UK employees used to be exempt from tax in some circumstances if they spent time working outside of the UK. This was achieved by applying Foreign Service Relief. This has now been abolished for all employees apart from seafarers if they are tax resident in the UK in the year that their employee terminates their contract.

Settlement legal costs

For the agreement to be legally binding, the employee must seek independent, professional advice before they sign to confirm they understand the terms they are agreeing to, such as waiving their employment law rights.

Usually, employers will pay the legal costs for this advice, and this would be included as a term in the agreement.

You should discuss this with your employer before engaging an adviser to confirm if and how much they will cover for your legal expenses in relation to the settlement agreement.

These legal costs will not count towards the £30,000 settlement agreement tax exemption provided the costs are solely connected to the termination of your employment and are paid to the adviser directly.

Settlement agreement tax advice

Entering into a settlement agreement can be a stressful and highly-charged process. It will be critical that you are happy with the terms before you sign.

As this is a complex area, and as each settlement agreement is unique to the case, take advice from a specialist in employment law before accepting and signing any package agreement to ensure you fully understand the terms you are agreeing to and the level of payment you will receive, including any settlement agreement tax you may have to pay.