When you have been offered a Settlement Agreement it’s important to understand what your tax implications will be for each type of payment. You may be offered different types of payments, some being contractual and others as an extra payment, sometimes called ex gratia.*
The Ex Gratia Termination Payment
If you have been offered a Settlement Agreement by your employer, you may be offered an ‘ex gratia termination payment’ as an incentive to settle any of your potential Employment Tribunal/County Court claims.
‘Ex gratia’ means ‘as a gift’. This means that your employer has no obligation to make this payment to you under the terms of your contract of employment (with the exception of redundancy payments).
There is a specific tax law which allows the first £30,000 paid as compensation for loss of employment/office to be tax free. So any termination payments in excess of the first £30,000 are taxable at whichever tax band your total earnings fall under.
Redundancy payments are tax free, even when included as part of your employment contract. This is because a redundancy payment is intended to relieve suffering (such as the loss of your job and income) rather than considered as earnings.
A redundancy payment can only be made when there is a genuine redundancy situation. Therefore it is important to know the reason why your employer is offering you a Settlement Agreement, especially if it involves you leaving your employer.
If HMRC find it is not a genuine redundancy situation, it has the right to claim tax. Like termination payments, the first £30,000 of contractual and statutory redundancy payments are exempt from tax.
Payment in Lieu of Notice/Notice pay (PILON)
Your contract of employment should state what notice pay you would be owed if you are leaving your employer. If your employer is offering you Payment In Lieu Of Notice, often referred to as a ‘PILON’, then the tax position depends on what your contract of employment says.
- If your contract states that your employer can make a Payment In Lieu Of Notice then it is not an ex gratia payment and it is taxable.
- If there is no mention of Payment In Lieu Of Notice in your contract of employment, then the payment is considered as an ex gratia payment for tax purposes and will not be taxed. It will be included in your £30,000 tax free allowance.
Payment of Wages
Your usual wages are taxable as usual as they are part of your normal earnings.
Any holiday pay is taxable as usual.
Restrictive Covenants and Confidentiality Payments
Restrictive Covenants and the duty of confidentiality are usually included in your contract of employment so you’ll need to check what your contract says. For more information see Is a Restrictive Covenant Preventing You from Changing Jobs?
Payments for agreeing Restrictive Covenants and/or confidentiality clauses are considered to be earnings and are therefore taxable.
Injury to Feelings Payments
Compensation for injury to feelings arising from unlawful discrimination that happened before your employment ended/ends is not be taxable. However, if the injury to feelings was caused by the termination it will be taxable.
Contributions to Registered Pension Scheme
Payments made directly into a pension scheme are treated separately and are not subject to tax. There are annual and lifetime allowances for contributions to registered pension schemes, and contributions in excess of these allowances do incur tax charges.
Contributions to the cost of outplacement counselling or similar training are not taxable and are usually paid directly by the employer. This means such costs do not count towards the £30,000 exemption.
Usually the employer contributes to your legal costs to see a Solicitor to make the Settlement Agreement legally binding. This does not count towards the £30,000 exemption as long as it is solely in connection with the termination of employment. There is usually a clause in the Settlement Agreement stating that legal costs should be paid directly to your Solicitor. Sometimes your legal costs will be included in the termination payment offered to you. If this is the case, you can discuss this with your Solicitor.
What Other Payments are Taxable?
There are a number of other categories of pay or benefit which are considered taxable earnings. There is a list on the HMRC website.
The £30,000 tax free limit can apply to more than one Settlement Agreement depending on the circumstances.
With the right advice you can reduce your tax liability and maximise the Settlement Payment you receive. Taxable sums are usually contractually owed sums such as your usual salary, holiday pay, notice pay, bonus, and commission payments.
At Co-op Legal Services our Employment Solicitors offer a range of fixed fee services. This means you know exactly what is included in the service you select and there are no nasty surprises. Once we have provided you with a written quote for the agreed work, that price will not change.
Our highly experienced Solicitors can help you with advising on the terms and effect of the clauses in your Settlement Agreement. We can also help you negotiate better terms, such as a higher Settlement Payment under our settlement negotiation service.
We can also provide you with legal advice on a potential Employment Tribunal Claim, either through a telephone assessment or investigation report.
*Please note that this article is written as a guidance on what possible payments are taxable in a Settlement Agreement and is not intended as legal advice. Should you have specific questions on your tax position then you should seek independent specialist advice from a tax lawyer or an accountant.