It can be overwhelming deciding what to do once you've received a settlement agreement from your employer. The thought of having to deal with the tax implications of receiving a settlement agreement payment may bring additional stress.

At Thompsons Solicitors, we have a team of experienced settlement agreement solicitors who can provide free and independent legal advice on the process of signing an employment settlement agreement. In this guide, we explore the rules around settlement agreements and tax.



How much tax do you pay on a settlement agreement?

A settlement agreement may be subject to tax in England and Wales, depending on the type and value of the payments you receive as part of your settlement.

The settlement agreement offered by your employer usually consists of a variety of payments. There are certain payments that are taxable, while others are tax-free.

Generally, the first £30,000 of your main settlement payment (sometimes referred to as a compensation payment or an ex-gratia payment) is tax-free.

When you’re leaving a job, HMRC classifies all payments you get from the company as "termination payments," whether they're redundancy payments, unfair dismissal compensation, pay in lieu of notice (PILON), holiday pay, or simply any wages owed.

Tax laws covering termination payments will apply if the payment is made because your employment is being terminated, regardless of the reason.


What is tax indemnity in a settlement agreement?

A settlement agreement usually includes a tax indemnity clause.

If HMRC determines that your tax-free payment should have been taxed in full or in part, then they will contact your employer as the tax should have been deducted at source through PAYE.

The tax indemnity clause normally stipulates that if such a demand is made, you will indemnify your employer against it, which essentially means you will pay the tax demand if HMRC asks them to pay tax on that payment.


Is a redundancy payment taxable?

It is common for employers to use settlement agreements in redundancy situations, sometimes to avoid redundancy procedures.

On these occasions, if you are entitled to a statutory redundancy payment, your employer will usually include this in your settlement agreement.

Statutory redundancy payments are calculated by looking at your length of service, weekly pay and age. They are also subject to a cap, which changes each year. You can visit the government website to calculate your current entitlement.

Any statutory redundancy payment you receive can be paid tax-free in full.

Depending on your employment contract, you may be entitled to more than the statutory minimum if you are made redundant. This is known as a contractual redundancy payment.

The first £30,000 of a contractual redundancy payment is tax-free – anything over this amount is taxable.

It’s important to note that the £30,000 threshold applies to the total of the compensation payments you receive on termination of your employment.


Is a payment in lieu of notice taxable?

If you receive a payment in lieu of notice (PILON), that payment is treated as salary and will be taxed as such.

If you don’t serve your whole notice period and you also don’t receive a PILON, then a percentage of your settlement payment will be treated as post employment notice pay (PENP). This is also treated as salary and taxed in kind.

There is no way to avoid paying tax on notice pay.


Are wages taxed if paid as part of a settlement agreement?

In most settlement agreements, you will be paid up to the termination date as normal. Since these wages are part of your earnings, they will be taxed in the usual way.


Is holiday pay taxable?

Upon termination of your employment, you’re entitled to be paid for any holiday leave you haven’t taken. This also forms part of your taxable income, regardless of whether it’s paid under a settlement agreement.


Why should I use Thompsons’ settlement agreement solicitors?

Our specialist settlement agreement unit is made up of employment lawyers with extensive experience in supporting people to secure the best agreement possible. We pride ourselves on providing a fast, efficient and reliable service, finalising settlement agreements with even the most urgent deadlines.

If you would like support with your settlement agreement, request a call back here. A specialist lawyer will contact you at your preferred date and time to discuss your case and run through what will happen next.