Tax Implications of Settlement Agreements

Are settlement agreements taxable?

Some of a settlement agreement is taxable and some is not. Redundancy pay and genuine compensation for loss of employment are tax-free up to £30,000 under sections 401 to 403 ITEPA 2003. Salary, holiday pay, bonuses and payment in lieu of notice are taxed in full as normal earnings, on top of that allowance, regardless of what the settlement agreement itself calls them.

HMRC sets out how the exemption is worked out in its Employment Income Manual (EIM13000 onwards), and ACAS guidance on settlement agreements covers how tax is usually discussed during negotiation. The rest of this page breaks down which specific payments fall on each side of that line.

Is a settlement agreement tax-free?

Not entirely. The part that is genuine compensation for loss of employment is tax-free up to £30,000under sections 401 to 403 ITEPA 2003. Salary, holiday pay, bonuses and PILON are always fully taxable, on top of that allowance, whatever the agreement itself calls them.

What payments in a settlement agreement are always taxable?

Certain settlement agreement payments are fully subject to income tax and National Insurance regardless of how they are labelled in the agreement. These include outstanding salary, accrued holiday pay, bonuses, commission, and PILON where a contractual PILON clause exists. Use our settlement calculator to see roughly how your settlement breaks down between the tax-free £30,000 and the taxable portion.

How is payment in lieu of notice taxed in a settlement agreement?

Since April 2018, all contractual and non-contractual PILON is taxable as earnings under the Post-Employment Notice Pay (PENP) rules in sections 402A to 402E of ITEPA 2003, with the formula itself set out in section 402D. The PENP formula calculates a notional notice pay amount that is treated as employment income regardless of whether your contract contained a PILON clause -- only any excess above that calculated figure can potentially qualify for the £30,000 exemption. See our payment in lieu of notice guide for how PILON fits into a wider settlement.

The PENP formula, in plain English

HMRC's formula is PENP = (BP × D / P) − T, where BP is your basic pay for the shortest pay period before termination, D is the number of calendar days left in your notice period that you did not work, P is the number of calendar days in that same pay period, and T is any contractual PILON already taxed separately. In plain terms: it works out what you would have earned for the unworked part of your notice, and taxes that amount as earnings no matter what the settlement agreement calls it.

These figures are illustrative only, not statutory rates. In this example, £8,000 is taxed as earnings through PAYE (with employee and employer National Insurance due on it), and only any further genuine termination compensation above that £8,000 can qualify for the £30,000 exemption.

What is a tax indemnity clause?

A tax indemnity clause is a promise, usually from you to your employer, to cover any extra tax or National Insurance HMRC later decides is owed on your settlement payment, if the £30,000 exemption is claimed and HMRC later disagrees with how much of the payment qualified. It shifts the risk of a wrong tax call from your employer to you, which is why it is worth understanding before you sign.

Most settlement agreements include one because employers want certainty that they will not be chased for unpaid PAYE if the tax-free portion is later challenged. A solicitor reviewing your agreement should check the indemnity is capped or reasonable in scope, since an unqualified indemnity can leave you liable for tax, interest and penalties on the full amount years later.

What settlement agreement payments can be tax-free?

Genuine compensation for loss of employment -- collectively called termination payments -- can be paid free of income tax and employee National Insurance up to £30,000 under sections 401 to 403 ITEPA 2003. This covers ex-gratia payments, statutory and enhanced redundancy pay, and compensation for unfair dismissal or discrimination. The key test is whether the payment flows from the employment relationship or from its termination. See our redundancy pay tax guide for how this applies specifically to a redundancy package, and our garden leave guide if you were kept on full pay during your notice period rather than paid it off in one sum.

• Ex-gratia payments (compensation for loss of employment)
• Statutory redundancy pay
• Enhanced redundancy pay above statutory minimum
• Compensation for unfair dismissal or discrimination
• Damages for breach of contract (beyond notice)

How much tax will I pay on my settlement agreement?

The table below shows the tax-free and taxable split for five common settlement amounts, assuming the whole sum is genuine termination compensation with no PILON, outstanding salary or holiday pay in the mix. PENP (payment in lieu of notice, calculated under the s.402D formula) is always taxable in full and sits outside this split.

PENP is taxable in full and is not shown here: add any PENP figure to the taxable element above. Use our redundancy tax calculator to work out the split for your own payment, including any PENP element.

How does a typical settlement agreement tax breakdown work?

In a typical settlement the total payment combines several components, some fully taxable and some qualifying for the £30,000 exemption. The example below shows how a £50,000 package splits: the taxable elements are processed through PAYE in the normal way, while the ex-gratia element up to £30,000 is paid gross.

What else should you consider about tax when accepting a settlement agreement?

Beyond the £30,000 exemption, several structural choices can affect your tax position. These include the tax year in which payments are received, whether any sum can be routed into your pension, and whether previous termination payments from the same employer reduce the available allowance. A specialist solicitor will flag these points during the review.