Tax is one of the most misunderstood aspects of settlement agreements. Employees want to know how much they will actually receive in their bank account; employers want to minimise the risk of HMRC challenging the treatment of payments later. While every case must be reviewed individually, some general principles apply across Great Britain.
Payments that represent earnings are subject to income tax and national insurance in the usual way. This category includes salary, overtime, taxable benefits, accrued holiday pay, and most payments in lieu of notice. Following changes to the rules on post‑employment notice pay, even non‑contractual notice payments are often treated as fully taxable earnings.
By contrast, genuine compensation for loss of employment can, in many situations, benefit from the £30,000 tax‑free exemption for qualifying termination payments. Amounts above £30,000 are taxable, but typically not subject to employee national insurance. Whether a payment falls within this exemption depends on its nature, not just the label used in the agreement, so careless drafting can create unwanted tax liabilities.
Other elements of a settlement package have their own rules. Payments solely for injury to feelings arising out of discrimination, where they are not connected with the termination itself, may be treated differently from termination‑linked compensation. Employer contributions towards the employee’s legal fees for advice on the settlement agreement can sometimes be paid tax‑free to the solicitor if properly structured. Outplacement or retraining support may also qualify for favourable treatment where it meets HMRC requirements.
Because tax law and HMRC practice evolve, settlement agreements usually contain detailed tax clauses and indemnities. These clarify who bears responsibility if HMRC later determines that additional tax is due. For employers, this can help manage risk. For employees, it is important to understand the practical effect of any indemnity before signing.
Taking advice from a solicitor who is familiar not only with employment law but also with the tax aspects of termination packages is therefore essential. They can ensure that the agreement reflects the true nature of each payment, maximises available reliefs within the rules, and avoids surprises when HMRC or a future adviser reviews the documentation.
Below are five additional, SEO‑focused article drafts you can use or adapt for settlementagreementssolicitors.uk, written for Great Britain (England, Wales and Scotland, excluding Northern Ireland).
