A settlement agreement (formerly called a compromise agreement) is a legally binding contract between an employer and an employee that settles potential or actual employment claims. The employee agrees to waive their right to bring specified claims in return for a financial payment and, often, other terms such as an agreed reference. The tax treatment of settlement agreement payments depends on how the payment is structured and classified.
What Makes a Settlement Agreement Valid
For a settlement agreement to be legally binding, it must meet specific requirements under the Employment Rights Act 1996:
- It must be in writing
- It must relate to a particular complaint or proceedings
- The employee must have received independent legal advice from a qualified adviser (typically a solicitor) on the terms and effect of the agreement
- The adviser must have a current professional indemnity insurance policy
- The agreement must identify the adviser by name
- The agreement must state that the statutory conditions have been met
The employer usually contributes towards the employee’s legal costs — typically £350 to £500 plus VAT — as a separate term within the agreement.
Typical Components of a Settlement Payment
A settlement payment often consists of several elements, each with different tax treatment:
| Component | Description |
|---|---|
| Termination payment | Compensation for loss of employment (ex-gratia payment) |
| Pay in lieu of notice (PILON) | Payment instead of working the contractual or statutory notice period |
| Outstanding salary | Unpaid wages up to the termination date |
| Accrued holiday pay | Payment for untaken annual leave |
| Bonus | Any bonus earned but not yet paid |
| Restrictive covenant payment | Payment for agreeing to post-termination restrictions |
| Legal fees contribution | Employer’s contribution to the employee’s legal costs |
Tax Treatment
The £30,000 Exemption
Genuine termination payments — compensation for loss of employment — benefit from a £30,000 tax-free exemption. This includes:
- Ex-gratia payments made as compensation for termination
- Statutory redundancy pay (counts towards the £30,000 limit)
- Enhanced redundancy pay above the statutory minimum
The first £30,000 of qualifying termination payments is free from income tax. Any amount above £30,000 is taxable at the employee’s marginal rate through PAYE.
Employer NICs on Excess
Since April 2020, employer Class 1A NICs are charged on termination payments exceeding £30,000. Employee NICs are not charged on termination payments (whether below or above £30,000).
Summary of Tax Treatment by Component
| Payment Element | Income Tax | Employee NICs | Employer NICs |
|---|---|---|---|
| Termination payment (first £30,000) | Exempt | Exempt | Exempt |
| Termination payment (above £30,000) | Taxable via PAYE | Exempt | Class 1A |
| Post-employment notice pay (PENP) | Taxable via PAYE | Class 1 | Class 1 |
| Outstanding salary | Taxable via PAYE | Class 1 | Class 1 |
| Accrued holiday pay | Taxable via PAYE | Class 1 | Class 1 |
| Bonus | Taxable via PAYE | Class 1 | Class 1 |
| Legal fees | Exempt (if paid direct to solicitor) | Exempt | Exempt |
| Restrictive covenant payment | Taxable via PAYE | Class 1 | Class 1 |
Post-Employment Notice Pay (PENP)
Since April 2018, any payment in lieu of notice — whether or not the contract contains a PILON clause — is taxable as earnings. HMRC requires employers to calculate the post-employment notice pay using a specific formula:
PENP = ((BP × D) ÷ P) − T
Where:
- BP = basic pay in the last pay period before termination
- D = number of calendar days in the unworked notice period
- P = number of calendar days in the last pay period
- T = any taxable termination payment already made (e.g. garden leave pay)
PENP is taxed as earnings — subject to income tax, employee NICs and employer NICs. It does not benefit from the £30,000 exemption.
Structuring the Payment
Example
An employee earning £50,000 with a 3-month notice period is made redundant. The employer offers a settlement:
| Component | Amount | Tax Treatment |
|---|---|---|
| Outstanding salary | £2,000 | Fully taxable |
| Accrued holiday pay | £1,500 | Fully taxable |
| PENP (3 months’ notice) | £12,500 | Fully taxable as earnings |
| Termination payment | £40,000 | First £30,000 tax-free; £10,000 taxable |
| Legal fees | £500 + VAT | Exempt (paid to solicitor) |
The employer processes the taxable elements through the final PAYE payroll run.
Processing Through Payroll
Employer Obligations
- Classify each payment element correctly — separate taxable earnings from qualifying termination payments
- Calculate PENP using the statutory formula
- Apply the £30,000 exemption to the qualifying termination payment
- Deduct PAYE and NICs on taxable elements through payroll
- Pay employer NICs on any termination payment exceeding £30,000
- Issue a P45 after the final payment
- Report all payments through RTI
Legal Fees
The employer’s contribution to the employee’s legal costs is tax-free provided it is paid directly to the solicitor, not to the employee. If paid to the employee, it becomes taxable earnings. The payment should be referenced separately in the agreement.
Negotiation Points
For Employers
- Ensure a clean break — the agreement should cover all potential claims
- Get the tax treatment right — incorrect classification can lead to HMRC enquiries and penalties
- Include a tax indemnity — the employee indemnifies the employer against any additional tax liability if HMRC challenges the treatment
- Agree an announcement — control the internal and external communication about the departure
- Agreed reference — provide a reference as part of the settlement terms
For Employees
- Take independent legal advice — this is a legal requirement for the agreement to be valid
- Understand the net payment — factor in tax on elements above £30,000 and on PENP
- Negotiate the split — maximising the genuine termination element and minimising PENP can improve the after-tax position
- Check redundancy pay entitlement — statutory redundancy pay is a right, not a concession, and should be in addition to any enhanced payment
Record-Keeping
The employer should retain:
- A signed copy of the settlement agreement
- The PENP calculation workings
- Payroll records showing the breakdown of payments and deductions
- Evidence that legal fees were paid directly to the solicitor
- All correspondence related to the settlement
Records should be kept for a minimum of 6 years for HMRC compliance purposes.