Are Settlement Agreement payments tax-free?

  1. If a sum within the settlement agreement is paid pursuant to a contract ­ for example: a payment in lieu of notice (PILON) where a PILON clause is contained in the employment contract; a payment for accrued holiday; anything deemed to be ‘salary’ ­ then it will be taxable. This is because the sum is classed as ‘earnings’.
  2. If a sum within the settlement agreement is genuinely “ex-gratia” or compensation for loss of employment then up to £30,000 of it can be paid ‘tax-free’ (or rather, taxable at 0%). Statutory redundancy payments and enhanced or contractual redundancy payments come under the £30,000 tax-free exemption. Over £30,000, sums of these types will be taxable at the individual’s normal rate.
  3. Payments that relate to restrictive covenants are taxable. If a sum is not attributed to “new” restrictive covenants then this should be agreed so that the entire compensation package does not become taxable.
  4. Payment of the employee’s legal fees within the settlement agreement is tax-free (to the extent that they relate to advice on the settlement agreement). This is an advantage for the employee who would otherwise be paying their legal costs out of taxed income. (N.B. The VAT on the legal costs will not be recoverable by the employer.)
  5. If an employee has more than two years’ service then payment for outplacement assistance is tax-free.
  6. More often than not a settlement agreement will include a tax indemnity outlining that tax will be paid by the employee if the payment is assumed to be tax-free but becomes taxable. However, the settlement agreement should outline that the employee is not responsible for any penalty charges issued by HMRC if they were caused by the employer.