Settlement agreement tax implications

Some of your settlement payment may be free of tax.

When you sign a settlement agreement, usually you’ll be agreeing to get some compensation, and other payments, in return for giving up your rights to bring claims against your former employer. Some payments will be taxable, but compensation of up to £30,000 is usually payable free of tax.

> View settlement agreement basics.

What payments do you get in settlement agreements?

When your employment ends, you will always be entitled to be paid up to the termination date.  You will also be entitled to paid in respect of holiday that has accrued up to termination. If you are being made redundant after more than two years’ employment, you should be entitled to statutory redundancy pay.

Assuming you aren’t being summarily dismissed (say, for gross misconduct) you should also be paid in respect of your notice period.  This will either be your statutory minimum notice entitlement or the notice period in your contract of employment, whichever is the longer. Statutory minimum notice entitlement is basically one week’s notice per year of employment, up to 12 weeks’ notice after 12 years’ service.

You may also be entitled to pro-rated bonus or commission payments, pension contributions, compensation for loss of benefits (car, private medical, etc) but this will be dependent on the terms of your contract of employment.

So much for the entitlements. You can “pocket” these – your employer isn’t adding any value or benefit to you in paying what you’re entitled to anyway.

In addition, you would expect to be paid compensation in respect of your loss of employment. More on this below, but there has to be a benefit – a sweetener – to you in signing a settlement agreement and giving up your claims.

How much of a settlement agreement is tax free?

Payments that are contractual or statutory entitlements, like salary, holiday pay, and notice pay, are all taxable in the usual way.  As such, PAYE and National Insurance will be deducted by the employer at source before these payments are paid to you.

Statutory redundancy pay is never taxable, but it does count towards your tax free compensation allowance of £30,000. Compensation for loss of employment can be paid free of tax up to £30,000.

However, the amount of compensation in excess of £30,000 is taxed at your usual rate.  So, if you’re paid £35,000 compensation, the top £5,000 of that is taxed.  Your employer has to deduct PAYE and National Insurance from the excess over £30,000. They also have to pay employer’s National Insurance contributions on the excess.

If you receive a payment in respect of disability, (which may happen if you’ve suffered disability discrimination) such as a lump sum in relation to permanent health insurance, then that is tax free in full.  This happens pretty rarely though, so I’m not going to go into more detail here.

How is PILON payment calculated?

Pay in lieu of notice (PILON) is basically the salary you would have earned had you worked for your notice period, rather than having your employment terminated and being paid in lieu of working your notice.

It should be straightforward, but it’s important to get the calculations correct.  All payments in respect of notice are taxable at source under PAYE, and National Insurance Contributions are also payable.

Employers can check they’ve got it right by calculating the post employment notice pay due to the employee, and ensuring that the PILON in the settlement agreement is at least this amount.

PILON relates to payment of salary in lieu of notice.

Do you pay VAT on settlement agreements?

VAT isn’t relevant to employment related payments – emoluments – like salary, notice and holiday pay.  We don’t tend to see VAT added to employment compensation payments for loss of office/employment.

However, VAT does come into play in relation to an employer’s contribution to the employee’s legal fees for advice on the settlement agreement.  Employers will have to pay the VAT element as well as the basic fee amount.

As explained in our Settlement Agreement Solicitors fees page, the employer usually covers all the employee’s fees on a straightforward settlement agreement – we find that a standard contribution of £500 plus VAT covers our fees for an employee where they are happy with the offer.

When we’ve advised an employee on a settlement agreement, the terms will generally require us to send our invoice straight to the employer. The settlement agreement usually states that we have to address the invoice to our employee client but mark it “payable by…” the employer.

Without delving into the tax rules too deeply, the employer can’t reclaim the VAT back on their contribution to the employee’s fees, because the services weren’t provided to the employer.  So, in the rare cases where we are asked to readdress our invoice to the employer, we always refuse. The employer is effectively asking us to enable them to reclaim the VAT which of course would be wrong – and solicitors can’t be involved in tax fraud.

How can I avoid paying tax on my redundancy payment?

If you’re receiving more than £30,000 compensation, as mentioned above, the excess over £30,000 will be taxable. It may be possible to pay some or all of the excess over £30,000 into your pension, as a tax efficient way of dealing with that slice of the compensation.

Whether you’re able to do this will depend on your individual position.  We would always suggest that you take specialist tax and/or pensions advice on your options.

Where do you put redundancy on a tax return?

Where you have received compensation for loss of employment, your employer will have to declare the payment to HMRC, and you should also declare it via a tax return.  In the employment section of the self assessment tax return form, there is a box where redundancy, post employment notice pay, and compensation payments can be included.

You may need to do a tax return anyway, or may need to do a return because you’ve received compensation under a settlement agreement. It’s worth getting tax advice whether you’re used to filling in a tax return or not, to ensure that you include everything you need to.

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