Are payments made under a settlement agreement taxable?

Whether or not payments made under a settlement agreement are taxable depends on to what the particular payment relates. A termination package in a settlement agreement will typically comprise various contractual and non-contractual elements, some of which may be liable to income tax and some of which may be tax-exempt. The tax position of termination packages is complex, so this answer provides a summary only. The nature of the event bringing about the termination of employment is another factor that can further complicate the tax position. The employer should start by precisely identifying each payment within the termination package and then considering the tax provisions applicable to it.

As a general rule, payments chargeable to income tax under s.62 of the Income Tax (Earnings and Pensions) Act 2003 include: outstanding salary payments and holiday pay; other earnings derived from employment such as outstanding bonus or commission payments; non-cash benefits in kind, such as the retention of a company car; other payments made under the employee's contract of employment; a contractual payment in lieu of notice or pay received while on garden leave; a payment to induce the employee to enter into or abide by post-termination restrictive covenants; and payments given in connection with termination of employment that cannot be charged to income tax in any other way, to the extent that, as a whole, they exceed £30,000.

There is a £30,000 exemption in s.401 in respect of those elements of the termination package not otherwise chargeable to income tax that are received in consequence of the termination of employment. The first £30,000 of the following payments benefits from the tax exemption referred to above: statutory, contractual and ex gratia redundancy payments made on account of genuine redundancy; and non-contractual ex gratia payments made as compensation for loss of employment, eg anticipated damages on account of unfair dismissal and non-contractual pay in lieu of notice on wrongful dismissal.

In some cases, a non-contractual payment that an employer is accustomed to making or that the employee reasonably expects to receive will be judged to be employment earnings and thus taxable. This is often the case where there is no contractual pay in lieu of notice clause in the contract of employment, but the employer generally pays in lieu when dismissing an employee.

Finally, the payment of legal costs by the employer direct to the employee's solicitor in respect of the settlement agreement is not subject to tax as long as the payment is made pursuant to a specific term in the settlement agreement and is in discharge of the solicitor's costs incurred solely in connection with the termination of the employee's employment.

Changes to the rules on taxation of termination payments will come into force on 6 April 2018. Under provisions in the Finance (No.2) Act 2017, all termination payments that would have been treated as general earnings if the employee had worked his or her notice period will be subject to tax and national insurance; all payments in lieu of notice, whether contractual or not, will be subject to tax and national insurance; and the £30,000 exemption will apply to payments relating directly to the termination of the employment. The changes will affect payments made on or after 6 April 2018 in relation to terminations that take place on or after that date.