Employers who reach settlement terms with a departing employee generally do so on the mutual understanding that the first £30,000 of any termination payment can be made tax free. This exemption is clearly set out in Income Tax (Earnings and Pensions) Act 2003 which states that payments up to this ceiling can be made tax free if they are compensation for termination of employment and are not otherwise subject to tax. However, this does not tell the whole story. Employers negotiating settlement terms with departing employees need to be aware of potential pitfalls. Here are some key pointers:

Notice pay is taxable

It is not possible to terminate employment with immediate effect and then redirect a sum of equivalent value to notice pay so that it is payable as tax free compensation. Since 2018, employers are required to apply a statutory formula to any termination payment offered to work out whether any of it is ‘post-employment notice pay’. If any of it is, then that portion will be taxable.

Compensation for injury to feelings can be made tax free

Payments specifically made in settlement of discrimination allegations can be made tax free.  The amount allocated to such a settlement needs to be clearly evidenced.

Payments in consideration for on-going contractual obligations are taxable

Settlement agreements often include clauses re-stating restrictive covenants or confidentiality obligations. Any payment offered in consideration for agreeing to these provisions must be subject to tax and national insurance deductions.

No employee national insurance contributions are payable on settlement sums

Employee national insurance contributions are not generally payable on any settlement sum reached, either under or over the £30,000 threshold. However, awards over £30,000 are usually subject to employer national insurance contributions.

Payments on account of disability can be made tax free

If the employee suffers from a recognised medical disability or injury which at the date the employee’s employment terminates prevents the employee from carrying out their job, a payment made solely on account of that disability or injury is exempt from income tax.

Written off loans will be treated as earnings

If a deal is reached to write off a loan as part of any settlement, then the amount of write-off will be subject to tax and national insurance deductions. Depending on the level of compensation payment being made to the employee (i.e. if it is under £30,000), it might make more sense to just increase the compensation payment paid to them to allow them to pay off the loan themselves. This will be more tax efficient for the employee than the employer writing it off.

Top tips for employers

Employers negotiating an exit package with an employee should:

  • Always carry out a calculation of ‘post employment notice pay’ and retain your workings. Guidance can be accessed here.
  • Make sure you don’t offer something that you are not (legally) able to. Any offer made in broad terms should always be made ‘without prejudice and subject to contract’ – making it clear that there may be additional terms (including statements regarding the tax treatment of sums payable) to which the offer is made subject.
  • Consider including a tax indemnity, allowing you to reclaim any unexpected tax demand from the employee.
  • If a settlement is complex or the sums involved are large, consider taking tax advice.