The Tax Treatment of Compensation Payments

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

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.

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:

• unfair dismissal
• 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.

Any sum paid as compensation that is over £30,000 will normally be subject to income and national insurance deductions.

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. Compensation for ‘injury to feelings’ arising from a discrimination claim that is unrelated  to termination of employment may not be taxable. This applies even if the employee is paid other compensation, say for loss of net income, which exceeds £30,000. However, compensation for injury to feelings that is connected to the termination of employment is likely to be taxable, following the most recent case law on this issue. It is possible to apportion sums but care must be taken and this is a key area of where the expert advice from Quantrills can make all the difference.

Compensation for any personal injury is normally paid gross without any tax or national insurance deductions, again, even if other compensation exceeds £30,000.

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

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.

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 from Her Majesty’s Revenue and Customs (‘HMRC’) in relation to certain payments. If HMRC gives advance clearance it cannot, at a later date, seek to recover tax on those payments.