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The tax treatment of compensation payments

Posted on 24th June 2013
Briefing note

The taxation of any payment paid under a settlement agreement can substantially affect the net amount of compensation you end up with. Use this Briefing note to understand which payments may be taxed or can be paid tax-free.

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Meet the author

Adrian Green Adrian
Green
Senior Employment Law Solicitor Telephone: 01473 694403

Compensation payments linked to discrimination or disability claims may also be paid without any tax or national insurance deductions

How much tax will I need to pay?

The amount of tax that you need to pay on any payment under a settlement agreement will depend on the amount and what it is for. Some payments can be made tax-free whilst others must be taxed.

What payments must be taxed?

As a general rule, any sum that you are entitled to under your contract of employment that relates to your past or future  employment is generally taxable in full. Therefore, payments made in the circumstances below will normally be taxable and suffer deductions of income tax and national insurance contributions:

  • your salary or wages and accrued holiday entitlement up to and including the termination date of your employment. This is the case even if you are on garden leave
  • any payment in lieu of notice made under a contractual pay in lieu of notice clause
  • a payment in lieu of notice paid under an established “custom and practice” arrangement
  • a payment of contractual bonus or commission that has or will become due as payable to you.

New restrictive covenants and protection of confidential information

Additionally, if you are required to enter into new restrictive covenants or extended obligations relating to your employer’s confidential information great care must be taken to ensure you pay tax on only a small proportion of the compensation payment. This is because both requirements require the employer to make income tax deductions on all or some of the compensation payment in such cases.

At Quantrills our employment law solicitors will make sure this issue is correctly dealt with so that any tax deductions are kept to the absolute minimum.

What payments may be made tax-free?

The first £30,000 of any non-contractual compensation paid to you by your employer as a result of the termination of your employment may be tax-free. This includes any compensation for:

  • compensation for unfair dismissal
  • compensation for unlawful discrimination
  • a statutory or enhanced redundancy payment
  • payment for non-contractual benefits in kind; and
  • a payment for damages for breach of contract. This can include a payment made by your employer in lieu of notice provided there is no contractual right to do so or when there is no custom and practice by your employer to pay in lieu of notice tax-free.

Compensation for discrimination and personal injury

Compensation payments linked to discrimination or disability claims may also be paid without any tax or national insurance deductions. Special care has to be taken when working out if any tax is payable but in many cases, compensation for ‘injury to feelings’ arising from a discrimination claim may not be taxable. Likewise compensation for any personal injury is also normally paid grosswithout any tax or national insurance deductions. In both cases the payments remain tax-free even if the employee is paid other compensation, say for loss of net income, which exceeds £30,000. In practice this means that some employees can receive tax-free a total compensation payment well in excess of £30,000.

Payments for legal fees, outplacement and re-training

Payment of legal fees and VAT and outplacement counselling will not normally attract tax subject to certain conditions, including payment direct to the provider of the service. At Quantrills we will make sure your agreement correctly deals with this issue.

Payments into a pension scheme

Your employer may be allowed to make tax–free payments into a registered pension scheme that you are a member of. If the amount paid into the scheme is below your annual allowance and your lifetime allowance limit then the payment should avoid being taxed. Special rules apply which we will advise you about.

Employee’s tax indemnity and advanced clearance

Your employer is likely to require you to accept liability for tax payable on the compensation payments paid under the settlement agreement which is not deducted at the time of payment to you. Hence, almost all settlement agreements include a tax indemnity in favour of the employer from the employee. Making sure the wording is no more onerous than is necessary is a key part of our work when negotiating the terms of a settlement agreement for a client.

If payments are large, and your potential liability significant, you (and your employer) may want assurances that the payments do not attract tax. You can ask your employer to seek clearance in relation to certain payments from Her Majesty’s Revenue and Customs (‘HMRC’). If HMRC gives advance clearance it cannot, at a later date, seek to recover tax on those payments.

How can you reduce the amount of tax you pay?

If possible, it is important to get the employer to agree that all payments can be structured in the most tax efficient way.
If your compensation payment does not exceed £30,000 then it is likely that all of it except any contractual payments can be paid to you tax-free. However, any payment in excess of £30,000 will need to be taxed unless it can be paid in a tax-free way.

Can we help you?

The settlement agreement solicitors at Quantrills can advise and help you to maximise the amount of the tax-free compensation.

To discuss your case it's easy - please contact us.

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