Compromise agreement: tax free?
- Matt Gingell
- Updated: Tue, 10th Jan 2017
Payments under a settlement agreement (also known as a compromise agreement) are one of the only remaining ways an employee can receive tax free payments. However this does depend on getting the structure and wording right.
Ensuring employees benefit under a settlement or compromise agreement
We set out below some points to bear in mind when entering into a settlement agreement:
- Typical scenario and how not to deal with payments under a settlement agreement
- The correct way to deal with payments under a settlement agreement
- Taxation on the payment made for shares given up on leaving employment
- Taxation in relation to share options on leaving employment
Consider this typical scenario involving a compromise agreement
An employee is made redundant. The settlement reads:
“You will receive a payment of £100,000 in compensation for loss of office which includes your entitlement to statutory redundancy of £2,800. We believe that the first £30,000 is payable tax free under s.403 ITEPA.”
The settlement agreement further states:
“…at the point of the Employee leaving the Company, a transfer notice will be deemed to have been served which will require the Employee to sell the Shares back to the Company”
The employee now seeks legal advice…
The compromise or settlement agreement
The lawyer notes that there’s no reference to him receiving a payment in respect of his six month notice period and no PILON, (pay in lieu of notice), in his contract. The employee is on a salary of £100,000. The payment looks to be made up of:
- His statutory redundancy payment;
- An enhanced redundancy payment;
- Together with a payment in damages for the employees notice period; and
- A payment of £50,000 in respect of shares in the employer he is forced to sell on leaving employment.
The lawyer knows that the first £30,000 of such sums can be paid tax free under current legislation. The employee is on a salary of £100,000. So his lawyer advises that whichever way you cut it, he’s entitled to £30,000 free of tax.
Our stressed and worried employee signs the settlement agreement. Sometime later, he fills in his tax return. Our employee, still job hunting, receives a letter from HMRC asking for details of the sums he was paid, in respect of which tax was not deducted. HMRC ask to see the:
- Settlement agreement;
- Contract of employment;
- Together with a note stating that the £50,000 is made up of his:
- Statutory redundancy payment,
- An enhanced redundancy payment, and,
- A payment in damages for his notice period, as advised.
HMRC then makes a demand for payment of tax in respect of £100,000 less £2,800 = £97,200. HMRC states the wording of the settlement agreement refers to only one payment that’s capable of being paid free of tax. This was the statutory redundancy payment, so that’s the only amount our poor employee is entitled to receive tax free. The settlement agreement is stated to be the entire agreement between the parties, so that’s all that is relevant.
Back goes our hero to the lawyers who advised him. And, what they tell him, as they blow the dust off their insurance policy is…..
“It depends upon the Tax Tribunal…”
Case law for taxation of payments under a settlement agreement
There are two conflicting cases on tax and settlement agreements:
- Reid v HMRC : which supports HMRC’s position. The details of tax free payments have to be set out in the compromise agreement;
- Johnson v HMRC : where the Tax Tribunal said HMRC was obliged to make enquiries beyond the terms of the compromise agreement to identify the different elements of a lump sum payment, even if there’s an “entire agreement” clause.
The correct way to deal with payments under a settlement agreement
It’s best to have each element of a payment on leaving the employer broken down in the settlement agreement. Even if HMRC is willing to make enquiries to establish what elements of a lump sum payment are tax free, if any, it’s much simpler if they don’t have to.
Why the wording matters
The correct wording benefits both the employee and the employer. Remember that HMRC can seek to recoup any unpaid tax and social security contributions, called national insurance in the UK, directly from the employer. HMRC can seek to recoup this money from the employer, even if the employee has provided an indemnity to the employer. Most employers simply don’t want devote the time to enforcing such provisions.
- But, some employers will enforce where the amounts involved are considerable and it is not nice for the employee to live with the risk.
Further tax payable in the future
HMRC are tightening the treatment of tax free payments to departing employees. From April 2018, it will no longer be possible to include damages paid for loss of notice period in the £30,000 tax free allowance. The effect of this – income tax and NICs will be payable on all payments made in relation to notice periods. This is whether or not there is a contractual PILON.
From a practical perspective, there will be no reason not to include PILON clauses in employment contracts. PILON clauses add flexibility; employers can terminate the contract early by paying the employee for their notice period. PILONs do benefit employers. This is because the restrictive covenants are preserved for the employer using a PILON. The employee is kept out of the market for the length of the PILON.
Taxation of the payment for shares
Our hero received a payment of £50,000 in respect of the shares he was forced to sell on leaving employment. Because the share based payment was wrapped up with income based payments in the settlement agreement HMRC assessed the share based payment to income tax and national insurance.
If properly advised, share based payments should not be dealt with in a settlement agreement. This is because payments on shares can be brought within the capital gains tax regime which carries a much lower rate of tax. Mixing capital payments with income payments is not a good idea from a tax perspective.
Correct approach for share based payment
If the share payment had been reviewed by an expert solicitor with tax knowledge the advice would have been:
- The highest rate of income tax plus national insurance is over 50%. The lowest rate of capital gains tax is 10%. It does pay to review the position on whether tax on the share based payment can be minimised. Set out the consideration payable for the shares in a separate share purchase agreement which sits independently to the settlement agreement. The purchase agreement can include in its terms that the share payment stems from share ownership rather than employment. HMRC do accept this distinction.
- Consider whether the payment offered of £50,000 is adequate. In public companies determining the value of shares is usually not controversial as the share price is in the public domain. However, in private companies the value of shares is usually up for negotiation. There are many ways to approach valuation each of which will depend upon the individual circumstances. It pays to remember that the employer may not be making his best offer first.
- Consider the capital gains tax implications. There are various capital gains tax saving opportunities which are quite legitimately available.
- Not every employment lawyer will have the relevant expertise you will need so do raise the issue.
Taxation in relation to share options on leaving employment
Let’s now assume that our employee also holds unapproved share options. Unapproved options do not benefit from the same tax advantages as HMRC approved option plans. They are usually adopted when the company can not meet the HMRC’s qualifying conditions.
The rights applicable to the options are usually detailed in the scheme rules. These should be reviewed before agreeing the terms of the settlement agreement as there may be room to improve the employer offering particularly where board discretion is permitted.
Effect of termination on share options
Unvested options usually lapse and hence fall away on termination. Some option plans however, allow leavers to retain vested options or exercise vested options following termination, in some instances up to six months following termination.
Many option plans distinguish between good leavers and bad leavers. Options will usually lapse in a bad leaver situation. Redundancy usually falls within the meaning of a good leaver.
Taxation of unapproved share options: that are exercised
Usually UK resident employees who exercise unapproved share options will pay income tax on the value of the shares less the exercise price paid. Any income tax and national insurance contributions that are due will be paid by the employer under the PAYE regime.
Some types of unapproved option schemes are structured in a way that means gains are subject to the lower rate capital gains tax regime rather than income tax. We can review the documentation and advise.
Taxation of unapproved share options: that lapse
Where share options are cancelled or lapsed, income tax will also arise on any payment made to the employee in lieu of the cancellation of the share option. This will not fall under the £30,000 tax exemption.
Dealing with share options in the settlement agreement
Most settlement agreements contain an entire agreement clause so it is important to ensure that the settlement agreement addresses what is to happen with any share options.
If the settlement agreement is entered into after the termination of employment date, options and awards may already have lapsed under the relevant plan rules. If this has happened, they cannot be revived.
Excluding liability for loss of share options
Employers often try to exclude the company’s liability for any loss of an employee’s rights under option plan caused by termination. Provisions are often contained in the settlement agreement and for senior employees or directors can also be within the employment agreement.
Summary of important points that can arise under a settlement agreement
Remember: not all employment lawyers are tax experts! The tax treatment of payments made under a settlement agreement are tricky.
Getting the wording right
The wording of the settlement agreement or compromise agreement is important and can save you a great deal of tax.
If your employer makes a contribution to you pension as part of the termination payment under the settlement agreement this may qualify for tax exemption but you need to ensure that the structure of the settlement agreement reflect the statutory requirements for qualifying pension payments.
Payments qualifying for tax exemption
Certain other payments in addition to the £30,000 tax free payment on redundancy or loss of office can also qualify for tax exemption.
The typical type of payments that can qualify for tax exemption under a settlement agreement relate to payments following claims of discrimination on any ground but usually sex, race or disability discrimination.
Separate agreement dealing with shares
If you are receiving consideration for giving up your shares you need to ensure that this is taxed as a capital payment rather than as an income payment as part of the settlement agreement.
- You should enter into a separate share purchase agreement. There are opportunities with share based payments to reduce your overall tax liability.
Deal with share options before the termination date
Unless dealt with whilst employed, shares option may lapse automatically on the date of termination. Usually exercised options are taxed as to income under PAYE but there may be scope within the rules to treat any gain under the capital gains tax regime.
HMRC will not help you to save on the tax payable – you have to help yourself!
Matt Gingell is a partner in our employment law team. He regularly advises employees and directors from a range of sectors on their settlement/compromise agreements. Matt’s solutions include taxation advice and where appropriate advice on taxation of payments received in respect of shares and options. We are able to deal with all of the aspects arising seamlessly.
I advise on a great many settlement agreements which includes solving issues relating to tax and share based payments. My expertise lies in knowing how HMRC will approach the issues.