Tax treatment in settlement agreements
Employment Law- tax treatment in settlement agreements
Will you be taxed on the ex-gratia payments in your Settlement Agreement?
Ex- gratia payments are made by your employer as compensation when you leave employment, which is over and above what you are entitled to be paid in your contract of employment (such as notice, bonuses and holidays). As a general rule, the first £30,000 of such payments can be paid free of tax and NICs.
If a settlement agreement offers compensation which exceeds £30,000, the excess will be subject to tax at your appropriate marginal rate. Compensation payments are not earnings for NIC purposes and are exempt from NIC completely even if they exceed £30,000.
If you have been made redundant, will redundancy payments be payable tax free?
Both contractual redundancy payments and statutory redundancy payments fall within the £30,000 exemption. Once you have reached the £30,000 ceiling for any combination of these payments and/or an ex-gratia payment, you will have to pay tax.
What about pension contributions?
HMRC treats payments made direct into pension schemes totally separately from the £30,000 exemption and they are not subject to tax.
Will your pay in lieu of notice be taxable?
If you have a clause in your contract which allows your employer to pay your notice as a lump sum instead of working it, this is known as a payment in lieu of notice or “PILON” clause for short.
If you have a PILON clause in your contract, your employer is required to make tax and National Insurance deductions. If, however, your contract does not have a PILON clause, and your employer opts to pay you in lieu, the payment is able to fall within the £30,000 available tax free exemption (because such payment is outside the terms of your contract).
Where there is a custom and practice by your employer to make a payment in lieu of notice, despite the absence of a PILON clause, HMRC may determine that tax should be deducted, because of this custom and practice.
If you work your notice or are placed on garden leave for the notice period, it is irrelevant whether or not you have a PILON clause in your contract, as the salary you receive will automatically be subject to tax and NICs.
Will your salary, bonus and benefits be subject to tax as normal?
Your salary, benefits and bonus entitlement payable up to and including the termination date will have tax and national insurance deducted in the usual way. You cannot shift a bonus payment due on termination into the tax free exemption by referring to it as part of your compensation, if the intention is to avoid paying tax on sums properly due.
If you have accrued but untaken holiday, will the pay in lieu be taxable?
Payments in lieu of accrued holiday will be taxed in the same way as salary. They cannot be part of the tax free exemption.
Are contributions to outplacement services taxable?
Contributions to outplacement services not taxable, and also do not count towards the £30,000 exemption. These costs are sometimes paid directly to the outplacement provider instead of to you first.
Should the consideration payment for restrictive covenants be subject to deductions?
Sometimes, the settlement agreement will require you to comply with new restrictive covenants, or confirm the existing covenants which appear in your contract of employment. In order to make these terms binding and enforceable, an employer needs to provide a nominal payment for this, which is known as “consideration”. A typical payment is a nominal sum of around £100 – £200 and it is always subject to tax and NIC deductions.
Are there any other payments which are also subject to tax?
Some settlement agreements may also contain a small consideration sum to make a confidentiality clause binding, and this too will be taxable.
Taxation of share options and share awards
You may be entitled to exercise share options and receive share awards either before or at some point after termination. The tax and NICs liabilities will depend on many factors including whether the scheme is tax-advantaged, the length of ownership and the reason for cessation of employment. A cash cancellation or compensation payment will be fully taxable.
Can payments for injury to feelings and discrimination be paid tax free?
If the payment relates to injury to feelings, and the discrimination giving rise to the payment is not related to the termination of employment (i.e. in relation to events prior to the termination), it can generally be paid tax free.
What if the termination payments stagger a tax year?
Most termination payments are made in one lump sum, but there are instances where the payments are staggered or delayed. It may be better from a tax perspective for some of the payments to be made in a new tax year, and in some cases, it is worth considering a specific request to your employer to delay payment, especially where large sums are involved.