The month of January in 2025 brought forth a startling report from the UK – its public sector showed the highest surplus on record at £15.4 billion, beating the number predicted by the Office for Budget Responsibility by quite a decent margin.

This figure seems much lower than the projected £20.5 billion surplus and it would seem like the UK continues to undershoot its expectations. To add to the Office’s disappointment, underperformance has been reported yearly since 2021, and this number is no different.

What is a settlement agreement?

In the United Kingdom, settlement agreements are designed primarily to resolve an employment dispute or problem between the employee and employer while allowing the employment contract or position to be terminated.

This includes separation agreements that clearly state the terms of parting ways and delineate compensation clauses. The comprehension of how the payments tied to these agreements are taxed is of utmost importance as it dictates how much an employee gets after tax.

The two notable and most common types are redundancy, workplace conflict resolution, and amicable parting ways. It is important to note that such agreements can only be made under the condition that the employee has sought external legal advice and that such agreements are written with clear terms regarding which exact claims are being resolved.

Tax-free payments under settlement agreements

In the United Kingdom, there is a provision for making specific payments in a settlement agreement without tax cuts on that particular clause, rather than an account.

• Statutory redundancy pay: Redundancy dismissals have also grown popular recently and such statutes are known to be tax-free under this context.
• Compensation for loss of employment: Payments made as reliefs but not contracts-based are tax-exempt up to £30,000. This also includes ex-gratia payments and certain damages.

It’s important to note that the £30,000 exemption applies to the total of all relevant payments. Any amount surpassing this threshold will be subject to income tax. For example, if an employee receives £35,000 as a compensatory payment, £5,000 will be taxable.

Taxable payments within settlement agreements

National Insurance contributions and income tax will apply to certain portions of the settlement agreement.

• Unpaid wages and holiday pay: Any earnings before the termination date, including pay for unused leave, are taxable.
• Payment instead of notice (PILON): If there is a PILON provision in the contract or company practice, those must be paid as earnings.
• Bonuses and commissions: All earnings that are tax-inclusive such as bonuses or commissions before termination will be taxable.
• Payments for restrictive covenants: Compensation for the acceptance of restrictive covenants such as non-compete clauses are taxed too.

All of those payments have to be deducted under the PAYE system from the employer’s side.

Understanding payment instead of notice (PILON)

A payment to an employee remission of the notice period to work their notice is what PILON means. The nature of the contingency will determine the tax implications of PILON.

• Contractual PILON: If the employment contract has a provision that includes PILON, this amount is regarded as payment and is therefore subject to taxation.
• Non-contractual PILON: Regardless of whether or not it is written in the employment contract, a PILON is taxable. This is by attempts to prevent employers from attempting to avoid taxes by changing the compensatory payment structure.

For example, an employee earning a salary of £3,000 per month receives PILON payment for two months. The amount of £6,000 will be taxed as income and also a payment towards National Insurance.

The role of tax indemnity clauses

To mitigate the consequences regarding tax liabilities IHRC might place on them in the future, employers include tax indemnity clauses in the settlement agreements. Such clauses put forward that if the amount of tax that is owed according to the HMRC is considered, the employee will pay for the taxes, interests, or penalties that arise for the employer. This means that the employer will not lose out if the settlement has tax implications leading to the tax being challenged.

Special considerations

• Non-cash benefits: If a company has agreed to let an employee keep their company car or laptop as a settlement, there might be additional tax to pay on those benefits.
• Share options and awards: How tax is calculated on benefits associated with the shares depends on the terms contained within the share scheme as well as the settlement agreement. Some of them might lead to payment of income tax and National Insurance.
• Payments for injury or disability: Damage payments made on account of injury or sickness suffered in the course of employment are exempt from tax as long as they do not come under the category of discrimination compensation claims.

Common mistakes and how to avoid them

• Incorrectly categorising payments: Mixing taxable and nontaxable payments in the absence of supporting documentation can easily result in unexpected tax liabilities.
• Overlooking PILON provisions: Notional PILON is assumed to be tax-free in some cases, leaving the recipient open to consideration by the tax authorities in his payment.
• Neglecting professional advice: A lack of proper advice from tax consultants or lawyers means there may be a misunderstanding of tax laws which can end in problems with HMRC.

Steps to ensure compliance

• Seek professional guidance: Consult tax advisers or specialist employment solicitors regarding the nature of the settlement and its impact on tax liabilities.
• Review employment contracts: Check your contract on termination payment definitions. Are they defined as PILON in the document? What are the tax consequences?
• Ensure clear documentation: In settlement contracts, it must be specified clearly that different payments have distinct purposes, for accountability and tax purposes.

Conclusion

For example, in the United Kingdom, consideration of the tax treatment of settlement agreements requires more than just noting the amounts paid and any existing contracts.

Both sides of the agreement should understand how failing to do so would hurt them. This is where consultants can make a difference by helping a client every step of the way.

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