Are termination payments always tax-free?

I heard that a payment made under a settlement agreement is tax-free, is that true?

The short answer is no- not always. It is important to consider the reason for the payment being made and all the circumstances in the background. Payments made via a settlement agreement can arise for several different reasons. They may be redundancy pay (statutory redundancy or voluntary redundancy), accrued contractual entitlements, compensation for loss of employment or payments in respect of a tribunal claim or damages for wrongful dismissal (that is when an employer fails to provide the appropriate notice). The current position will see some changes when new law concerning termination payments takes effect in April 2018.

Isn’t there a £30,000 tax-free amount for termination payments?

There is legislation which provides for certain payments to be made tax free up to £30,000. This usually applies to redundancy payments and compensation payments but it should not be assumed that this will apply. In certain circumstances HMRC can look behind the wording of a settlement agreement and determine, for various reasons, that a payment does not fall within a category of payments capable of being paid tax-free in this way. 

Are payments in lieu of notice payable tax-free?

It depends on the wording in the employee’s employment contract (if they have a written contract) and the circumstances of the payment. Generally speaking, payments which are made as compensation for loss of notice entitlement and where there is no contractual entitlement for the employer to pay in lieu of notice, are capable of being paid tax-free up to £30,000. 

This is very much a generalisation and it is important to consider all circumstances, and take advice preferably at an early stage on all termination payments proposed so that you are fully aware of tax liability. 

Can a settlement agreement allocate tax liability?

Absolutely. It is very common for a settlement agreement to contain a clause called a ‘tax indemnity’. Very often this will allocate tax liability (and liability for NICs, penalties and expenses related to tax demands) to an employee. This is why it is particularly important for employees to understand the tax risk involved in any termination payments made under a settlement agreement so that they are as informed as possible before accepting any proposed termination payments or settlement package.

I think I will be offered a settlement agreement or termination payment- what should I say to my employer if this happens?

If you find yourself in a situation where your employer is proposing a settlement agreement and a termination payment try to get as much detail as possible on the different elements of the offer. It is good to understand timescales for considering any offer made but do try not to commit to proposal. Simply ask if it is possible to have this confirmed in writing and explain that you will take time to consider their offer.

Your employer might tell you that you will need to take legal advice on the settlement agreement but you would be well advised to take advice at an early stage, even before a settlement agreement is produced. If you do, your adviser can consider the proposal made and recommend an approach on tax risk as well as the best next steps to take.