Settlement agreements: an employers guide

Last Updated: July 20th, 2022

Settlement Agreements for employers

Poorly drafted settlement agreements expose employers to unnecessary cost. Properly drafted settlement agreements allow employers to terminate employment cost effectively without risking claims in the Employment Tribunal.

In addition to reading this article you may find our recent webinar guide to settlement agreements for employers useful.

How does a Settlement agreement protect the employer?

A settlement agreement is a form of employment termination agreement which, if properly drafted and where the employee accepts it and has received independent legal; advice, gives the employer legal peace olf mind that the ex-employee cannot bring any of the main employment law claims.

Settlement agreements are also a useful way for employers to include post termination rerstrictions on the employee. However, care is needed when including any form of employment restrictive covenants as if they are too wide ranging they may not be enforcerable.

A settlement agreement, that used to be termed a compromise agreement, should state it is in full and final settlement. Otherwise it does not serve its purpose.

We define and detail the payments made in full and final settlement. For example, the settlement agreement should separate tax free and taxable payments. We explicitly state what each item represents e.g. outstanding holiday pay to the date of termination.

How to avoid problems with HMRC when making tax free compensation payments to employees

HMRC investigations are becoming routine. HMRC want to see the nature of payments made to employees. HMRC  look for PAYE which employers should have operated, but did not.  Employers are liable for interest and penalties, if they fail to operate PAYE in accordance with the regulations.

In most cases, the employer is liable for the tax. HMRC is not overly concerned that employers may have difficulties recovering tax from employees. HMRC can pursue the employee for tax. In practice they pursue employers.

Settlement agreement tax indemnity

We include a good tax indemnity that makes it clear that the employee is liable for all tax on the payments made. However, the tax indemnity does not absolve the employer from the duty to operate PAYE.  Nevertheless, it creates a contractual right to recover the tax the employer pays under PAYE.

Enforcing the indemnity may be difficult if the ex-employee cannot be traced or pleads poverty. In such cases tax retention can help the employer. If the employer retains tax,  then we set out the details in the settlement agreement.

Settlement agreement: restrictive covenants

Employers usually have workable, enforceable non-compete and post-termination restrictions in an employment contract for a senior employee or director’s service agreement. In which case, unless the employee has breached the terms, the terms may not need repeating in the settlement agreement.

Sometimes restrictive covenants were not included in the employment contract for a member of staff who was junior when they started but is now in a senior position or are out-of-date, or not enforceable.

The settlement agreement provides an opportunity to create fresh restrictive covenants when an employee leaves.

What can be included

The post termination restrictions or restrictive covenants can cover a range of anti-competitive behaviour.  Typical requirements prevent the employee:

  • Joining a competitor;
  • Using the employer’s confidential information;
  • Poaching customers, clients and staff;

Protect employers property

Usually employers manage the return of company property such as  documents, phones, computers, etc. However, many forget to obtain passwords, and company property stores on employees’ devices, e.g. memory sticks and home computers. With no passwords, managers then waste considerable time accessing employees emails and hard drives.

The settlement agreement should include an undertaking from the employee to permanently delete any information belonging to the company from employee owned devices. Such clauses make it easier to enforce breaches by the ex-employee. This gives the settlement agreement more teeth.

Reputation management

It will not always be possible for an employee to take down his or her personal social media sites which may include references to the employer. However, the employer may well want references to the employment replaced. Increasingly, well drafted settlement agreements will include an undertaking from the employee to remove any references to the employer by the termination date.

Another angle is the risk of a dismissed employee seeking to damage the employer’s reputation. The settlement agreement should include a clause whereby the employee promises not to directly or indirectly make any derogatory or disparaging comments about the company or any of its employees.

Employee references

An employer has no legal obligation to provide an employee or former employee with a reference. However the reference is a powerful tool in the employer’s armoury. The possibility of a bad or no reference usually brings an employee to the negotiating table.

Employers have a duty to ensure the reference is truthful and reasonable. To protect themselves from claims, many employers just provide simple, factual references.

Simple reference

Settlement agreements often include an agreed form for the reference, that just confirm the:

  • Employee worked there;
  • Duration of employment; and
  • Employee’s job title.

Amending the reference

Employers can reserve the right to amend the agreed terms of the reference should information later come to light rendering the reference inaccurate.  This type of provision can help to stop the former employer making for example derogatory comments or using company information improperly.

Share rights

Often employees or directors must transfer shares when their employment terminates.  There can be additional tax risks if shares are linked with the employment agreement. Best practice is to manage share transfers under a separate share sale agreement.


Usually options lapse to the extent not exercised on cessation of employment.  This general rule applies to unapproved options as well as EMI options and HMRC CSOP options.

Alex Kennedy

I know that when the noise dies down there is a solution to be found. I set about that task as quickly as possible.

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