Are settlement agreements taxable?

What a settlement agreement actually pays for

A settlement agreement is a statutory contract recognised by section 203 of the Employment Rights Act 1996 and related legislation. To be valid it must be in writing, relate to particular complaints, and be signed after the employee has received advice from an independent legal adviser who is identified in the agreement and covered by insurance.

The total sum offered typically combines several distinct elements:

• Outstanding salary and accrued but untaken holiday up to the leaving date.
• Contractual entitlements such as bonus, commission or notice pay.
• An ex gratia or compensation element for the loss of the job itself.
• Sometimes a payment for agreeing to new restrictive covenants, or a contribution to legal fees or pension.

HMRC looks through the structure to the substance. Calling a payment “compensation” does not make it tax free if in reality it is deferred salary or a contractual bonus. This is why the wording and the apportionment set out in the agreement matter so much, and why a well drafted schedule of payments lists each element and its tax treatment on its own line rather than presenting a single undifferentiated figure.

The £30,000 tax-free exemption

The best known rule is the £30,000 exemption in sections 401 to 403 of the Income Tax (Earnings and Pensions) Act 2003. A payment that is genuinely compensation for the termination of employment, rather than a reward for work done, can be paid free of income tax up to a cumulative total of £30,000. Anything above that ceiling is taxable at the employee’s marginal rate.

A few points are easy to get wrong:

• The £30,000 is a single allowance across all termination payments connected to the same employment, not £30,000 per payment.
• Statutory redundancy pay is tax free but still counts towards the £30,000, reducing the headroom for other compensation.
• Benefits in kind provided as part of the exit, for example continued private medical cover or a retained company car, can use up part of the allowance.

Payments that are always taxable

Several common elements never benefit from the £30,000 exemption because they are, in law, earnings. These are subject to income tax and usually to employee and employer National Insurance in the normal way:

• Salary, wages and accrued holiday pay up to the termination date.
• Contractual bonuses, commission and similar performance payments.
• Payment in lieu of notice (PILON), whether or not the contract contains a PILON clause.
• Post-employment notice pay (PENP), the statutory calculation introduced from 6 April 2018 that taxes the value of any unworked notice even where the payment is dressed up as compensation.
• Payments made in return for agreeing to restrictive covenants such as non-compete or non-solicitation terms.

The PENP rules are the most technical part of this area. In broad terms, the employer must calculate how much of any termination payment reflects basic pay for the notice period the employee did not work, and tax that amount in full. Only the balance can potentially fall within the £30,000 exemption.

Payments that can usually be paid tax free

On the other side of the line, some elements can commonly be paid without deduction, provided the agreement is drafted correctly:

• Genuine compensation for loss of employment, up to the £30,000 ceiling.
• Statutory redundancy pay, within the statutory limits, though it counts towards the £30,000.
• Employer pension contributions paid directly into a registered scheme, which normally fall outside the taxable termination payment altogether.
• A contribution to the employee’s legal fees, where it is paid directly to the adviser and relates solely to advice on the termination.
• Payments genuinely on account of a disability or injury that caused the employee to leave, and certain injury-to-feelings awards for discrimination unconnected to the termination itself.

Whether an injury-to-feelings or discrimination element can be paid tax free is fact sensitive and contested, and the case law has shifted over the years, so it should always be checked with a specialist before anyone relies on it.

National Insurance and amounts above £30,000

Income tax is not the whole picture. The National Insurance position on the excess over £30,000 changed in recent years and is a frequent source of error:

• The employee pays income tax, but no employee National Insurance, on the taxable termination element above £30,000.
• Since 6 April 2020, the employer pays Class 1A National Insurance on the part of a termination payment that exceeds £30,000.
• Earnings elements such as salary, PILON, PENP and bonuses attract both employee and employer Class 1 National Insurance in the usual way.

Timing also affects the tax collected. If the payment is made after the P45 has been issued, the employer typically applies the 0T tax code, which can mean too much tax is deducted up front and the employee has to reclaim it from HMRC, or too little, leaving a bill later. Agreeing when and how sums are paid is therefore part of the negotiation, not an afterthought.

Common mistakes and a pre-signing checklist

Before signing, work through the following checks:

• Is every payment separately identified, with the tax-free and taxable elements clearly apportioned?
• Has PILON or PENP been calculated and shown as taxable, rather than hidden inside the “compensation” figure?
• Does the £30,000 allowance account for statutory redundancy and any taxable benefits in kind?
• Is the employer’s tax indemnity clause reasonable, and does it exclude the employer’s own National Insurance?
• Are pension contributions and legal fees routed directly to the scheme or adviser to preserve their treatment?
• Is the timing of payment, before or after the P45, understood and reflected in the figures?

Getting these wrong rarely changes the tax that is legally due, but it changes who bears it. A poorly drafted agreement can leave the employee facing an unexpected deduction, or the employer exposed under a broad tax indemnity clause. Where the numbers are large or the notice position is unusual, it is worth asking a tax adviser to model the PENP calculation and the position above £30,000 before the figures are fixed, because renegotiating after signature is far harder than getting the apportionment right first time.

Settlement agreements reward disciplined contract management, because the tax outcome turns on precise wording, correct apportionment and consistent figures across the schedules, indemnities and payment clauses. A single mislabelled sum or an overlooked PENP calculation can shift thousands of pounds of liability between the parties. Pactolane’s AI copilot, PactAI, helps a reviewer move faster by spotting the clauses that carry tax risk, extracting the payment elements and dates into a clear executive summary, and scoring the agreement’s overall risk, so nothing slips through before signature. It prepares the ground by flagging, extracting and alerting, while the individual and their legal adviser make the decisions. This guide is general legal information, not legal advice, and any figure or tax point should be confirmed with a qualified tax or employment adviser.