Tax free payments when leaving employment

Helping employees achieve the best outcome

Drawing on our experience of the areas employees frequently need help with, we have put together:

• Top 12 FAQs on tax-free settlement payments when leaving employment; and
• Guidance on dealing with share transfers and the tax arising on any gains.

Each year we review hundreds of settlement agreements for employees, senior executives and directors. We combine employment law and tax expertise. We can also advise on the corporate aspects of share awards. Usually, your legal costs are paid by your employer.

Guidance on how payments on leaving employment work

If a settlement agreement is not structured appropriately, you may lose available tax relief. HMRC may review settlement payments and seek additional tax where the treatment is incorrect. Don’t rely solely on your employer’s settlement agreement. It may not be drafted in a way that is tax-efficient for you.

The approach

To help you understand the tax treatment of payments on leaving employment, it helps to distinguish between::

• Income payments –potentially subject to income tax and National Insurance contributions (NICs) under PAYE, unless an exemption applies.
• Capital payments – potentially subject to capital gains tax (CGT), depending on the nature of the transaction and any available reliefs or exemptions.

Income payments: Top 12 frequently asked questions

Here are the most important questions to consider.

1. Are there separately agreed or identifiable sums of compensation?
2. • If yes: Each payment should be assessed according to its nature and purpose. Clear drafting can help demonstrate the intended allocation, but does not determine the tax treatment by itself.
   • If no: Where a genuine lump-sum settlement covers claims of different types, the tax treatment will depend on the circumstances and the nature of the payment.
2. Does the sum have the character of remuneration?
3. • If yes: It is generally taxable as earnings, with income tax and NICs applying under PAYE. Salary, bonuses, commission and holiday pay are treated as remuneration.
3. Is the sum payable for agreeing to a new or revised restrictive covenant?
4. • If yes:  A payment for entering into a restrictive covenant will generally be taxable as earnings under the relevant tax rules. The treatment of a payment relating to an existing restriction depends on the circumstances and the terms of the agreement.
4. Is the sum contractual Pay In Lieu of Notice i.e. a PILON?
5. • If yes: It is generally taxable as earnings under PAYE, with no £30,000 tax-free exemption. Review the employment contract or director’s service agreement to establish whether it includes a PILON clause. Tax may also apply to post-employment notice pay even where there is no contractual PILON clause.
5. Has the employer given you your full notice period?
6. • If yes: Salary paid during the notice period and holiday pay remain taxable under PAYE.
   • If no:. Post-employment notice pay (PENP) rules may make the basic pay relating to the unworked notice period taxable, even where the payment is described as compensation. Any remaining qualifying termination payment may benefit from the £30,000 exemption, subject to the applicable rules.
6. Is the sum genuine compensation for loss of employment?
7. • If yes: A qualifying termination payment may benefit from the £30,000 exemption. Any amount exceeding the available threshold is generally subject to income tax, although the precise treatment depends on the payment and applicable rules.
7. Does the sum compensate you for a breach or other loss. e.g., damages for wrongful dismissal, basic award or compensatory award for unfair dismissal, compensation for discrimination including injury to feelings?
8. • If yes: The tax treatment depends on the nature and circumstances of the payment.
   • If discrimination: Compensation connected with the termination of employment may be taxable in some circumstances. The reason for the payment and its connection with the termination must be considered.
   • HMRC clearance: In complex cases, specialist tax advice may help establish the appropriate treatment before payment is made.
8. Is the sum a redundancy payment?
9. • If yes: Statutory redundancy pay and qualifying additional redundancy payments may benefit from the £30,000 exemption, subject to the rules governing termination payments and any other relevant payments.
9. Is the sum an employer contribution to a registered pension scheme??
10. • If yes: Employer contributions may be made without an immediate income tax charge for the employee, subject to the applicable pension tax rules and allowances.
10. Will you continue to receive benefits in kind, such as a company car or private medical insurance?
11. • If yes: The usual tax rules for benefits in kind continue to apply, and you may remain liable for tax not already collected through PAYE.
11. Does the sum relate to the loss of share rights?
12. • Cash payments for loss of share option rights: These may be taxable as earnings under PAYE. For example, a payment arising because an EMI option has lapsed or an option under another approved scheme, such as a CSOP, has been lost may be taxable. The treatment depends on the particular arrangements.
    • Cash payments for shares: These should generally be considered separately from employment compensation because the tax treatment depends on the nature of the share transaction and the rights being transferred or cancelled.
12. Have you received a settlement agreement?
13. • If yes: The same general tax principles apply to payments made under a settlement agreement, although the treatment depends on the nature of each payment.

Collection of tax

Your employer is responsible for operating PAYE and deducting income tax and any applicable NICs from taxable payments. This means you will receive payment net of deductions where required. Most employers include a tax indemnity in the settlement agreement, under which the employee or director may agree to reimburse the employer for certain additional tax liabilities assessed by HMRC.

Employers who fail to operate PAYE correctly may face interest and penalties. They may seek to pass certain liabilities to the employee under a tax indemnity, so its scope and wording should be reviewed carefully.

Qualifying termination payments may benefit from the £30,000 income tax exemption, but this does not apply to all payments made on termination.

What if your settlement agreement is not well drafted?

If the settlement agreement does not clearly identify the sums attributable to:

• Tax free payments, and
• taxable payments;

HMRC may challenge the proposed tax treatment. The outcome will depend on the nature of the payments and the available evidence; the entire settlement is not automatically taxable simply because the drafting is unclear. HMRC may pursue the employer or, in some circumstances, the employee.

Capital payments: How to deal with shares held when leaving employment

Shares are generally governed by arrangements separate from the employment contract. A payment for the sale or transfer of shares will often be subject to CGT rather than income tax, but the treatment depends on the transaction and the rights involved. Payments for shares should therefore be considered separately from employment compensation.

Establishing share rights

Most employers require shares to be transferred when an employee leaves. These rights are often set out in the company’s articles of association or shareholders’ agreement as compulsory transfer provisions. In larger companies, the rights may be set out in the share plan rules or the terms of an LTIP.

A review of the relevant documents is needed to establish how much consideration the departing employee or director will receive if required to transfer shares. In private companies, the share value is often negotiated, which is a particular area of our expertise.

Minority shareholders in private companies

Calculating the value of shares held by minority shareholders in private companies can be particularly difficult. We often recommend appointing an independent valuation expert to help resolve disputes.

Payment of capital gains tax

The rate of CGT payable on gains from share transfers or buybacks depends on the circumstances and available relief. Business Asset Disposal Relief (BADR) may reduce the CGT rate where the relevant qualifying conditions are met. The questions to ask are:

1. Do you meet the conditions for Business Asset Disposal Relief?
2. • If yes: BADR may apply if the relevant conditions are satisfied. For qualifying disposals made on or after 6 April 2026, the rate is 18%. The conditions include requirements relating to the company, the shares and the individual’s employment or office, as applicable. A 5% shareholding is generally required, subject to specific exceptions, including for certain EMI shares.
   • If no: CGT will generally be payable at the applicable standard rate, depending on your taxable income and the type of asset.
   • If the company buys back and cancels the shares, different tax rules may apply. Capital treatment is not automatic and should be assessed before the transaction proceeds.
2. Have you made other taxable capital gains in the tax year?
3. • If no: You may be able to use your annual exempt amount to reduce your CGT liability.
   • If yes: Consider whether your other gains have already used your annual exempt amount. Any remaining allowance may be available against gains on the share disposal.
3. Are you married or in a civil partnership?
4. • If yes: You may be able to transfer shares to your spouse or civil partner on a no gain/no loss basis, subject to the relevant rules, to make use of their available annual exempt amount or tax bands when the shares are subsequently disposed of.
4. Can you split the gains between two or more tax years?
5. • If yes: Depending on the transaction and payment arrangements, spreading disposals across tax years may allow you to use more than one annual exempt amount. The timing and legal substance of each disposal must be considered carefully.

Timing of capital gains tax payments

For most share disposals, CGT is payable by 31 January following the end of the tax year in which the gain arises, where the individual is required to file a Self Assessment tax return. This is generally later than the deduction of income tax through PAYE on employment-related payments. The precise reporting and payment deadlines depend on the transaction and the taxpayer’s circumstances.