Tax free settlement agreement payments

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Payments under a settlement agreement (also known as a compromise agreement) are one of the only remaining ways an employee can receive a tax free payment.  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!   We work with both employees and employers to help them secure the most tax advantageous position achievable.

How to secure tax free treatment of your settlement payment

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  is important and can save you a great deal of tax.

Pension contributions

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.

We work with employers, employees and directors.  We review and sign settlement agreements once everyone is happy with the terms.