Will you secure a tax free settlement payment?
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 of the settlement agreement correct.
HMRC will not help you to save on the tax payable – you have to help yourself!
How to secure tax free treatment of your settlement payment
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 settlement payment
An employee is made redundant. The settlement agreement 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 details of the 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 demand for additional tax on the settlement payment
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 compensation payments under a compromise 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 settlement 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.
It is not 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.
Summary of important points
Remember: not all employment lawyers are tax experts! The tax treatment of payments made under a compromise 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 compromise agreement this may qualify for tax exemption but you need to ensure that the structure of the settlement agreement reflects 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, share options not exercised may lapse automatically on termination of employment. The tax payable will depend upon the type of option award.