Publish date

27 May 2022

Settlement agreements and ex gratia payment, what is taxable?

In the employment context, a settlement agreement is a legally binding contract that records the terms on which an employee waives any claims they may have against their employer.  It usually (but not always) also provides for employment to be terminated.

When employers offer a settlement agreement it would normally include a payment made from the employer to employee in return for the employee’s agreement not to pursue any claims in a Tribunal or a Court. This payment is often expressed as an ‘ex gratia’ (taken from Latin meaning ‘good will’), termination or severance payment.  For this article we will refer to it as ‘termination payments’.

How are termination payments taxed?

Termination payments can usually be paid tax free up to £30,000. This article is a reminder of the (not so favourable) tax treatment of similar payments and of the need to correctly assess all payments being made to an employee on termination in order to get the tax treatment right.

Upon the termination of an employee’s employment, some payments will be subject to the same tax and NI treatment as wages. The tax position of termination packages can be legally complex and will differ in certain circumstances. We have set out below a table showing payments commonly made on termination and the general rule regarding tax status.

Payment Subject to tax/NI deductions?
Termination payment (up to £30,000) Tax free.
Termination payment (over £30,000) The excess is subject to income tax and employer NICs (but not employee NICs).
Redundancy payment Both statutory and contractual redundancy payments are tax free up to £30,000.
Notice payment / payment in lieu of notice Subject to tax and NICs, regardless of whether the employee has a PILON clause (“payment in lieu of notice”) in their contract.
Bonus/commission payment Subject to tax and NICs.
Non-cash benefits in kind i.e., retention of a company car Subject to tax and NICs.
Untaken holiday Subject to tax and NICs.
Retention bonuses (made in return for employee agreeing to stay until a specified date, or performing certain duties) Subject to tax and NICs.
Payments for entering into restrictive covenants Subject to tax and NICs.
Injury to feelings payment Only tax free if it is related to a recognised medical condition or psychiatric injury and is the direct result of unlawful discrimination suffered by the employee prior to the termination of contract. If an injury to feelings payment is connected to/a result of the termination of employment, the amount will subject to tax.

Employers should remember to include a tax indemnity clause in the settlement agreement they offer as this will make it clear that the employee is liable to account to HMRC and/or the employer for any unpaid tax.

Taxation of termination payments can be complex and appropriate legal and tax advice should be taken by both the employer and employee before a settlement agreement is finalised.

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