Settlement Agreement Tax for Employers: What Payments Are Taxable?

Settlement agreement tax for employers can be complicated because different parts of the same payment may receive different tax treatment.

Some payments must go through payroll with deductions for Income Tax and National Insurance. However, the first £30,000 of a qualifying termination award may usually be paid without deductions.

Employers should separate each part of the financial package clearly. They should also avoid describing the whole payment as tax-free without first checking what each amount represents.

How does settlement agreement tax for employers work?

The tax treatment depends on the reason for each payment rather than the label used in the settlement agreement.

For example, an employer cannot turn unpaid salary into a tax-free payment simply by calling it compensation. HMRC will consider what the employee would have received and why the employer is paying it.

A settlement package may include:

• salary or wages owed up to the termination date;
• holiday pay, bonuses or commission;
• notice pay or post-employment notice pay;
• statutory or enhanced redundancy pay;
• compensation for the loss of employment; and
• payments for legal costs or other agreed benefits.

Each element should appear separately in the agreement. This helps the employer operate payroll correctly and allows the employee to understand the likely deductions.

Which settlement agreement payments are taxable?

Payments that arise from the employee’s contractual earnings will usually remain taxable. Employers must normally deduct Income Tax and employee National Insurance through PAYE.

This commonly applies to salary, holiday pay, commission, bonuses and other earnings owed when employment ends.

Payment in lieu of notice is also generally taxable. This applies whether the employment contract contains an express right to make a payment instead of requiring the employee to work their notice.

In some cases, the employer must calculate post-employment notice pay, often called PENP. These rules aim to ensure that the part of a termination award representing notice pay receives the same tax treatment as ordinary earnings.

Therefore, employers should not assume that an ex-gratia payment automatically qualifies for the £30,000 exemption.

When can the £30,000 exemption apply?

The first £30,000 of a qualifying termination award can generally be paid free of Income Tax. This amount may include genuine compensation for the loss of employment and qualifying redundancy payments.

The £30,000 limit applies to the combined qualifying payments arising from the termination. It is not a separate allowance for each payment described in the agreement.

Any qualifying amount above £30,000 will normally become subject to Income Tax. In addition, the employer must usually pay employer Class 1A National Insurance on the qualifying termination award above that threshold.

The employee does not normally pay employee National Insurance on the part of a qualifying termination award that exceeds £30,000. However, different rules apply to amounts treated as ordinary earnings.

Employers can learn more about the wider legal requirements on our settlement agreements for employers page.

Statutory and enhanced redundancy payments

Statutory redundancy pay can usually form part of the amount covered by the £30,000 exemption.

An enhanced redundancy payment may also qualify where it genuinely compensates the employee for the termination of their employment. However, any part representing salary, notice pay, holiday pay or another contractual entitlement will usually remain taxable.

For example, suppose an employee receives £12,000 statutory redundancy pay and £25,000 additional termination compensation. The combined qualifying award would be £37,000.

Subject to the circumstances, the first £30,000 may qualify for the exemption. The remaining £7,000 would normally attract Income Tax, while the employer may also owe Class 1A National Insurance on that excess.

Our article on redundancy settlement agreements considers how employers can use agreements during a redundancy process.

Payments for legal costs

Settlement agreements normally require the employee to obtain independent legal advice. Employers often agree to contribute towards the cost of that advice.

A payment made directly to the employee’s solicitor may receive different tax treatment from cash paid directly to the employee. The contribution should relate specifically to advice on the termination agreement and should reflect the amount invoiced.

The agreement should state the maximum contribution and explain whether it includes VAT. Employers should normally pay the solicitor after receiving an invoice addressed appropriately.

If an employer pays a general cash allowance to the employee and leaves them to arrange their own legal costs, HMRC may treat the payment differently.

Injury to feelings and discrimination payments

Payments connected with discrimination or injury to feelings require particular care. Their tax treatment depends on the nature of the claim and the events that gave rise to the payment.

A payment relating to discrimination that occurred before termination may not receive the same treatment as compensation arising directly from the loss of employment.

Employers should not allocate an artificial amount to injury to feelings simply to reduce tax. The agreement and surrounding evidence should support the purpose and value of the payment.

Where the settlement covers several claims, specialist tax advice may be necessary before the parties agree the final wording.

How should the agreement describe the payments?

The settlement agreement should provide a clear breakdown rather than one unexplained total.

It should normally identify:

• taxable salary, holiday pay and other earnings;
• notice pay and any PENP calculation;
• the qualifying termination payment;
• the amount, if any, above the £30,000 exemption;
• the employer’s contribution towards legal fees; and
• the deductions that the employer intends to make.

Clear drafting does not determine the tax position by itself. Nevertheless, it helps show that the employer considered each payment separately and applied the correct treatment.

Employers may also find our article on the Acas Code of Practice on settlement agreements useful when planning discussions and formal offers.

Tax indemnities in settlement agreements

Many settlement agreements contain a tax indemnity. This usually states that the employee will reimburse the employer if HMRC later decides that additional employee tax or National Insurance is due.

However, an indemnity does not remove the employer’s responsibility to operate PAYE correctly. Nor does it necessarily protect the employer against its own National Insurance liabilities, penalties or interest.

Employers should not rely on an indemnity as a substitute for checking the tax treatment before making payment.

Common settlement agreement tax mistakes

Employers can increase their financial risk when they:

• describe the entire settlement payment as tax-free;
• include notice pay within the £30,000 exemption;
• fail to calculate PENP where required;
• combine wages and compensation into one figure;
• overlook employer Class 1A National Insurance;
• use artificial payment descriptions; or
• make payment before payroll and legal advisers review the figures.

HMRC can examine the true purpose of a payment regardless of the wording used by the parties.

Advice on settlement agreement tax for employers

Settlement agreement tax for employers requires careful allocation of each payment. Earnings and notice pay will generally remain taxable, while genuine termination compensation may qualify for the £30,000 exemption.

EBS Law helps employers structure settlement agreements, identify the different payments and record the agreed terms clearly. Employers should also obtain specialist tax or accountancy advice where the package includes unusual or substantial payments.