Employment Law – Tax Treatment in Settlement Agreements

The tax treatment of payments made under a settlement agreement depends on what each payment is actually for.

Simply describing a payment as:

• Compensation
• Ex-gratia
• Tax-free
• Damages

does not determine how HM Revenue & Customs will treat it.

Different elements of the same settlement package can have completely different tax and National Insurance consequences.

The information below is general guidance only. Tax treatment can depend on individual circumstances, and specialist tax advice may be appropriate where substantial or complex payments are involved.

For general information about settlement agreements, see Settlement Agreements.

Will an Ex-Gratia Payment Be Tax-Free?

An Ex-Gratia Payment is commonly used to describe compensation paid in addition to sums you are already entitled to receive.

For example, it is usually distinguished from payments such as:

• Salary
• Holiday pay
• Bonus
• Commission
• Contractual notice pay

However, using the label ex-gratia does not automatically make a payment tax-free.

The tax treatment depends on the real nature of the payment.

Where an amount qualifies as a genuine termination award under the relevant tax legislation, the first combined £30,000 of qualifying termination payments can generally be paid without Income Tax.

The £30,000 exemption does not apply to ordinary employment earnings.

What Payments Can Fall Within the £30,000 Threshold?

Qualifying payments can potentially include:

• Statutory redundancy pay
• Enhanced redundancy payments
• Genuine severance compensation
• Certain non-cash termination benefits

The first combined £30,000 of qualifying amounts can generally be paid without Income Tax.

Income Tax is then generally payable on the qualifying termination award above £30,000.

The £30,000 amount is a combined threshold.

You do not receive a separate £30,000 exemption for:

• Redundancy
• Ex-gratia compensation
• Each individual settlement payment

Is National Insurance Payable Above £30,000?

There is an important distinction between employee and employer National Insurance.

For a qualifying termination award falling within the special termination-payment rules:

• The Employee does not generally pay Class 1 National Insurance merely because the qualifying award exceeds £30,000
• The Employer generally pays Class 1A National Insurance on the qualifying amount above £30,000

This employer Class 1A charge has applied since April 2020.

Ordinary earnings such as salary, bonus, holiday pay and PENP remain subject to the normal Class 1 National Insurance rules.

Are Redundancy Payments Tax-Free?

Statutory redundancy pay can form part of the £30,000 tax-free termination-payment threshold.

Qualifying enhanced or additional redundancy compensation can also fall within the same threshold.

For example, if you receive:

• £15,000 Statutory redundancy pay
• £25,000 Additional qualifying severance compensation

the total qualifying termination award is:

£40,000

Broadly, the first:

£30,000

can fall within the tax-free threshold, while the remaining:

£10,000

would generally be subject to Income Tax.

Your employer would also generally be liable for employer Class 1A National Insurance on the qualifying amount above £30,000.

However, any part of a payment that is actually:

• Salary
• Notice pay
• Holiday pay
• Bonus
• Commission

must be taxed under the normal earnings rules rather than being included in the £30,000 exemption merely because it appears in a redundancy settlement.

What About Employer Pension Contributions?

Employer contributions paid directly into a registered pension scheme as part of a termination arrangement can receive separate tax treatment.

Qualifying employer pension contributions are not generally treated as using up the £30,000 termination-payment threshold.

For example, depending on the circumstances, an employer might agree:

• £30,000 Qualifying cash termination compensation
• An Additional employer pension contribution

A qualifying employer pension contribution does not automatically have to be deducted from the same £30,000 termination-payment exemption.

However, it is incorrect to say that pension contributions are always completely tax-free without qualification.

Employer contributions remain subject to:

• Pension scheme rules
• Annual allowance rules
• Applicable pension tax legislation

A sufficiently large contribution could therefore have tax consequences for the employee.

Any pension contribution should normally be structured and agreed before the settlement payment is made.

Will Payment in Lieu of Notice Be Taxable?

Yes.

A Payment in Lieu of Notice, commonly called PILON, is generally taxable as employment income.

Income Tax and Class 1 National Insurance will normally be deducted.

This applies whether the payment is:

• Contractual
• Non-contractual

The modern tax rules are designed to ensure that employees cannot receive an unintended tax advantage simply because they do not work their notice.

For further information, see Notice.

Will Salary, Bonus and Benefits Be Taxed Normally?

Yes.

Amounts representing normal employment earnings are generally taxable in the ordinary way.

These can include:

• Salary
• Wages
• Bonus
• Commission
• Overtime
• Holiday pay
• Certain taxable benefits

Income Tax and applicable National Insurance will normally be deducted through payroll.

You cannot generally convert a payment that is genuinely salary or bonus into tax-free termination compensation simply by describing it differently in the settlement agreement.

HMRC considers the substance of the payment, not merely the label given to it.

What is Post-Employment Notice Pay?

Post-Employment Notice Pay, usually called PENP, is a statutory tax calculation designed broadly to identify the basic pay you would have received if you had worked the notice period to which you were entitled.

PENP rules have applied to relevant termination payments since 6 April 2018.

Where PENP arises, that part of a relevant termination award is treated as general earnings.

It is therefore normally subject to:

• Income Tax
• Employee Class 1 National Insurance
• Employer Class 1 National Insurance

It does not qualify for the £30,000 termination-payment exemption.

When Can PENP Apply?

PENP can become relevant where:

• Your Employment ends without full notice being worked
• You Receive a relevant termination award

The calculation is based on a statutory formula involving matters such as:

• Basic pay
• Length of the unworked notice period
• Relevant pay period
• Certain taxable notice-related payments already received

The detailed calculation can be technical.

For further guidance, see Post-Employment Notice Pay.

Is PENP Always Required if I Receive a Settlement Payment?

Not necessarily.

If you work your full notice period, there will generally be no unworked notice period for PENP purposes.

Similarly, where an amount already taxed as earnings fully represents the relevant notice pay, the PENP calculation may produce no additional taxable PENP amount.

However, employers should apply the statutory rules rather than simply assume that describing a payment as compensation prevents PENP from arising.

Is Accrued Holiday Pay Taxable?

Yes.

If you have accrued but untaken holiday when your employment ends, any payment in lieu of that holiday is treated as employment earnings.

It will therefore normally be subject to:

• Income Tax
• Employee National Insurance
• Employer National Insurance

It cannot be placed within the £30,000 termination-payment exemption merely by including it in a settlement agreement.

Are Outplacement Services Taxable?

Qualifying outplacement counselling and services can be exempt from Income Tax where the statutory conditions are satisfied.

Outplacement support can include professional services designed to help you:

• Deal with losing your job
• Search for new employment
• Prepare for interviews
• Develop a CV
• Plan your next career move

Where the statutory exemption applies, the value of those services does not use up the £30,000 termination-payment threshold.

The exemption is most straightforward where the employer provides or pays for qualifying services directly.

A cash payment given to you instead may not necessarily receive the same treatment.

Are Payments for Restrictive Covenants Taxable?

Yes, payments specifically made in return for entering into a restrictive covenant are generally treated as employment income.

Restrictive covenants can include promises restricting your activities after employment ends, such as:

• Non-competition obligations
• Non-solicitation restrictions
• Non-dealing restrictions
• Other relevant post-employment undertakings

A payment made for entering into such an undertaking is generally subject to:

• Income Tax
• Class 1 National Insurance

It does not ordinarily benefit from the £30,000 termination-payment exemption.

For further guidance, see Restrictive Covenants.

Does My Employer Have to Pay £100 or £200 for a New Restrictive Covenant?

There is no general tax or employment-law rule requiring a specific nominal figure such as £100 or £200.

Where fresh contractual restrictions are being introduced, questions can arise about whether appropriate consideration has been provided and whether the restrictions themselves are enforceable.

Those are contractual issues separate from the tax treatment.

If a specific cash payment is made for the restrictive undertaking, that payment will generally be taxable as employment income.

What About Payments for Confidentiality Obligations?

Settlement agreements frequently contain confidentiality provisions.

A separately identified payment made in return for entering into a new confidentiality or other restrictive undertaking can also require separate tax treatment.

Depending on the nature of the obligation, the payment may be taxable as employment income and should not automatically be treated as part of the £30,000 tax-free termination award.

The correct treatment depends on what the payment is actually being made for.

How Are Share Options and Share Awards Taxed on Termination?

Share options and share awards can be particularly complicated.

The tax position can depend on:

• Type of share scheme
• Whether the plan is tax-advantaged
• Date of grant
• Exercise date
• Market value
• Exercise price
• Leaver status
• Reason employment ended

For example, different rules can apply to:

• Enterprise Management Incentive options
• Company Share Option Plans
• SAYE options
• Share Incentive Plans
• Non-tax-advantaged options
• Restricted Stock Units
• Other employment-related securities

A payment received in return for releasing, cancelling or not exercising an employment-related share option can itself create an Income Tax charge under the employment-related securities rules.

The treatment should therefore be checked against the particular share plan rather than assuming that share-related compensation falls within the £30,000 settlement exemption.

For further guidance, see Shares and Stock Options.

Can Personal Injury Payments Be Tax-Free?

Potentially, but the rules are narrower than simply stating that all personal injury payments in settlement agreements are tax-free.

There is a specific exemption for certain termination payments made wholly on account of injury or disability.

For the exemption to apply, the circumstances must satisfy the relevant statutory requirements.

HMRC guidance indicates that the exemption can apply to:

• Physical injury
• Psychiatric injury

but not merely to injury to feelings.

In disability cases, HMRC will ordinarily expect appropriate medical evidence showing that the condition prevented the employee from carrying out the duties of the employment.

Where a settlement payment covers several different matters, it may be necessary to determine what proportion genuinely relates to the injury or disability.

Are Injury-to-Feelings Payments Tax-Free?

The tax treatment of injury-to-feelings compensation depends on what the payment relates to.

The position is more nuanced than saying that every injury-to-feelings payment is either automatically taxable or automatically tax-free.

Discrimination Before Termination

HMRC guidance states that where an injury-to-feelings payment can reasonably be attributed solely to discrimination occurring before termination, it can fall outside the special termination-payment charge because it is not connected with the termination itself.

For example, this could potentially concern compensation for discriminatory treatment experienced while the employment relationship continued.

The precise tax treatment should still be considered according to all applicable tax rules.

Discriminatory Termination

The position can be different where:

• The Dismissal itself was discriminatory
• The Compensation is connected with the termination

In those circumstances, the relevant compensation can fall within the termination-payment tax regime.

The injury or disability exemption does not include injury to feelings.

Where the payment qualifies as a termination award, the ordinary £30,000 termination-payment threshold may then be relevant, subject to the proper allocation of the settlement package.

What if the Settlement Covers Both Types of Discrimination?

Where a settlement resolves:

• Discrimination occurring during employment
• A Discriminatory dismissal

the different elements may need to be identified and apportioned on a reasonable basis.

Simply allocating a large figure to "injury to feelings" in the agreement does not bind HMRC if the allocation does not reflect the underlying facts.

For further information, see Discrimination.

Can a Psychiatric Injury Payment Be Tax-Free?

Potentially.

For the specific injury or disability termination-payment exemption, injury can include psychiatric injury.

However, the statutory requirements must still be satisfied.

In particular, the payment must genuinely be made on account of the qualifying injury or disability.

A payment for ordinary:

• Distress
• Humiliation
• Upset
• Injury to feelings

is not automatically a psychiatric injury payment for tax purposes.

Medical evidence can therefore be particularly important.

What Happens if Settlement Payments Are Made in Different Tax Years?

Settlement payments do not necessarily all have to be paid in one lump sum.

Sometimes the parties agree that payments will be made:

• By instalments
• At a later date
• Across more than one tax year

Receiving taxable income in a later tax year can, in some circumstances, affect the employee's overall Income Tax position because their income and tax bands may be different.

However, there are several important limitations.

Does the £30,000 Exemption Reset in a New Tax Year?

No.

The £30,000 termination-payment threshold is a combined exemption applying to the relevant termination.

It does not become another £30,000 simply because part of the same termination package is paid in a later tax year.

For example, you cannot normally obtain:

• £30,000 Tax-free in one tax year
• Another £30,000 Tax-free in the following tax year

from the same termination merely by staggering the payments.

Is a Payment Always Taxed in the Year the Money Reaches My Bank Account?

Not necessarily.

For relevant termination payments, HMRC's rules determine when a payment is treated as received.

Cash can be treated as received when:

• It is actually paid
• A Payment on account is made
• You become legally entitled to require payment

This means that simply asking an employer to delay transferring money may not move the tax liability into another tax year if you already had an unconditional legal right to receive the payment earlier.

If payments are intentionally structured across tax years, the settlement agreement should clearly address:

• Payment dates
• When each amount becomes legally due
• Conditions applying to payment

Tax advice may be particularly important where significant sums are involved.

Can My Employer Simply Agree That a Payment is Tax-Free?

No.

A settlement agreement commonly states how the employer intends to treat different payments for tax purposes, but the parties cannot override tax legislation by agreement.

HMRC can examine the true nature of the payment.

For example, a payment cannot normally become tax-free simply because the agreement calls it:

• Compensation
• Damages
• Ex-gratia

if it is actually:

• Salary
• Bonus
• Holiday pay
• Notice pay
• Restrictive covenant consideration

Settlement agreements commonly also contain a tax indemnity, under which the employee accepts responsibility for certain additional tax if HMRC later decides that more tax should have been paid.

The wording of any tax indemnity should therefore be considered carefully.

Why is the Payment Breakdown Important?

A settlement agreement should ideally identify the different elements of the package separately.

For example:

• Salary to termination
• Holiday pay
• Bonus
• PILON
• Statutory redundancy
• Additional compensation
• Pension contribution
• Legal fees
• Outplacement services
• Restrictive covenant consideration

This helps ensure that each element receives the appropriate tax treatment.

The most important principle is that each part of a termination package should be taxed according to what the payment is genuinely for, rather than according to the label placed on it in the settlement agreement.

Where a settlement involves substantial compensation, pension contributions, discrimination damages, international tax issues or share awards, specialist tax advice may be appropriate before the agreement is finalised.