If you’ve received a settlement agreement, you may be wondering how much tax you will have to pay on the payments you’re being offered.
The short answer is, as little as possible, provided the settlement agreement is drafted well. If you use up your holiday entitlement, work your notice period, and your payment is under £30,000, then probably nothing!
The amount of tax you pay will of course make a big difference in the amount you eventually receive, and the last thing you want after agreeing a settlement you are happy with is to find out later on that you’re not going to get what you thought.
The rules on taxation of payments made to you by your employer, including in settlement agreements, are covered by the usual tax legislation, namely the Income Tax (Earnings and Pensions) Act 2003 (ITEPA2003).
The rules are slightly different according to whether or not the settlement agreement is concerned with your leaving that employment. We’ll cover it either way.
Tax on settlement agreement when you are leaving or have left the job
When you’re leaving a job, whatever payments the company make to you are called “Termination Payments” by HMRC, regardless of whether they are redundancy payments, compensation for unfair dismissal, pay in lieu of notice (commonly abbreviated to PILON), payment for holiday accrued but not taken, or simply payment of the wages owed. As long as the payment is made because your employment is being terminated, for whatever reason, then the tax laws covering Termination Payments will apply.
The basic rule for a termination payment you receive as part of your settlement agreement is this:
The first £30,000 of an ex gratia termination payment is tax-free
In practice, it’s not always quite so simple to apply. To start with you have to ask what is meant by “ex gratia”. Ex gratia just means, as a gift. In the case of tax law and employment, it means your employer was not obliged to pay it under the terms of your contract of employment (with the exception of redundancy payments).
Often your total payment will be made up of several different payments. Some of these may be ex-gratia, some will not be.
Redundancy payments are tax-free (subject to the £30,000 threshold)
Redundancy payments are tax free even when provided for as part of your employment contract. The reason is essentially that a redundancy payment is a payment made to relieve suffering, i.e. the loss of job and income, rather than being earnings.
Naturally, a payment can only be a redundancy payment if your job is in fact being made redundant. It’s important to be sure that the reason for your being dismissed is actually redundancy in the eyes of the law.
This means that it’s the job you have been doing which is no longer needed, rather than you. A consequence is that nobody else can take over the job you’re leaving or have left because if they do, HMRC will argue that your payment was not for reason of redundancy and expect you to pay tax on it.
The tax free status of the payment is subject to the £30,000 limit.
Payment in Lieu of Notice could either be tax free or taxed
It depends on whether or not your original contract of employment entitled you to a payment in lieu of notice. If your contract says that you are entitled to it, then payment in lieu of notice is a payment your employer is obliged to pay you. As such, it is not ex gratia and will be taxable.
If your contract does not provide for payment in lieu of notice, then both you and your employer will be free to negotiate whether or not you will have pay in lieu of notice, and therefore they are not obliged to pay you. As such, the payment is ex gratia for tax purposes, and will not be taxed (up to the £30,000 limit).
Payment for wages owed will be taxed
Because wages due to you are part of your earnings, and not really to do with your leaving, they will be taxed as usual.
Payment for holiday not taken will be taxed.
If you had taken the holiday, and got paid, then that payment would have been taxed in the normal way, and so it is still taxable when paid as part of a settlement agreement.
Compensation is often tax free or partly tax free
Usually, compensation payments (eg for discrimination in the workplace) will not be taxable, but it depends on exactly what the money is for.
In general, compensation for things like pain and suffering or injury to feelings awarded by a court in the form of damages are not taxable. If such compensation is being paid under a settlement agreement, perhaps in preference to a court case, then the compensation will be completely tax free and will not count towards your £30,000 limit.
Payments for Entering Into Restrictive Covenants are Usually Taxable
A restrictive covenant is an agreement that you will not do certain things within a certain period after leaving or within a certain distance from your old place of work. Such agreements are usually concerned with your not taking business away from your employer. For example, if you leave a hairdresser’s salon, you might agree not to open your own salon within a mile of your employer’s salon for a year after leaving.
Payments for agreeing restrictive covenants are considered to be earnings and are taxable.
What other payments are taxable?
There are a number of other categories of pay or benefit which are considered taxable earnings. HMRC publishes a list: http://www.hmrc.gov.uk/manuals/eimanual/EIM00513.htm
The £30,00 tax-free limit could apply to more than one settlement agreement
It’s worth noting that the tax-free limit of £30,000 is an aggregate of all such payments in respect of that employment. If you have received payment from a previous settlement agreement, it could count towards the same limit. When adding up all the payments, you need to include all the payments from the same employment. For tax purposes, employments are considered to be “the same” where they are paid to you in connection with:
- the same job
- different jobs with the same employer
- different jobs with associated employers
For example; imagine you were dismissed by Lloyds Bank and received a payment of £25,000 in a settlement agreement, then got a job with Scottish Widows but were made redundant some time later and received a redundancy payment of £15,000. The two payments must be aggregated before applying the £30,000 limit because Lloyds Bank and Scottish Widows are both controlled by Lloyds Banking Group.
Tax on a settlement agreement payment when you are not leaving
When you are not leaving the job, or are carrying on with a different job with the same employer, the rules are slightly different from when you’re dismissed. There’s no £30,000 limit and most payments apart from compensation payments will be taxable as earnings.
If your settlement agreement is for a dispute concerning discrimination, or on account of an accident at work, then it will not be taxable, unless some of it is to make up for lost earnings, in which case that part will be taxable.
When the employer gets is wrong
Your employer should know all the above, but that’s not a guarantee that they will have got it right.
On the one hand, the bigger the company, the more likely they will have knowledgeable personnel. On the other hand, however, the more staff a company employs, the more likely they will have standard “boiler-plate” settlement agreements which will not be tailored to your own circumstances. For example, if you’ve agreed an ex-gratia termination payment with your boss, and the agreement comes through with some of the amount attributed to a payment in lieu of notice, then you will be taxed on that part unnecessarily.
The good news is that in order for a settlement agreement to be binding you have to get legal advice which your employer will normally pay for, and your solicitor should spot mistakes like that.
Watch out for the taxman!
Lastly, do please be aware that whether or not various amounts making up your payment fall into one category or another is a matter of fact, which means that even if your settlement agreement states that a payment is for one reason, if in fact it is for another reason, then it could prove taxable after all. If that happens, HMRC are able to pursue you for any tax which is payable.
What if I’ve already paid tax I shouldn’t have?
It does work both ways! If you have paid tax on your payment unnecessarily, then you should reclaim the over-paid amount from HMRC. You need to do this within four years of the end of the tax year for which the tax was paid. You can ask them either to pay the money to you, or use it to set-off against future tax due.
If the amount is significant, you will probably need the advice of a tax accountant or solicitor and ask them to make the request for you. If the amount is relatively small, you can apply yourself directly to HMRC: http://www.hmrc.gov.uk/incometax/overpaid-thro-job.htm
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If you have received a settlement agreement, you will need to make sure you receive legal advice on it.
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