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Settlement payments in employment law

Terminating a staff member’s employment is never pleasant for either side, but settlement payments can have an important legal use in some situations. It’s advisable that legal advice is sought by both sides, but an employee needs to receive independent legal advice on a settlement agreement before signing for it to become binding. Usually, the employer will contribute towards the cost of legal advice for the employee.

Here we answer your common questions on settlement agreements, and how payments are made.

What is a settlement agreement?

Simply put, a settlement agreement (formerly a compromise agreement) is a mutual agreement between an employer and employee to compromise any potential contractual and statutory claims an employee may have. This is usually, but not always, related to the termination of an employee’s employment.

Negotiating a settlement agreement

Whilst negotiating a settlement might be something that a business is prepared to do for itself, it is usually a good idea to seek legal advice. Our specialist employment lawyers can advise on any claims an employee might have and the potential value and likelihood of success of any such claims. We can also assist you, the employer, with all aspects of settlement agreements from drafting and negotiating, to completing and enforcing a settlement agreement.

You will want to consider more than just the headline settlement figure, as matters such as confidentiality, intellectual property (IP), business disruption and goodwill may also be of critical importance. Deadlines for negotiating a settlement agreements are often a good way to ensure that damage to the business is minimised but businesses know how long they can request information and assistance (by way of a handover, in particular) from an employee.

Is a settlement agreement legally binding?

Yes. A settlement agreement is legally binding if it is signed by both parties, it is in writing, refers to the particular complaint(s), and states that the applicable statutory conditions regulating the settlement agreement have been met. An employee must also have received independent legal advice on the terms and effects of the agreement, by the legal adviser named in the agreement, and that adviser must have a current contract of insurance or professional indemnity covering the risk of a claim by the employee in the case of any losses arising from the advice.

If you are an employee who has been offered a settlement agreement, our solicitors can provide advice and guide you through the process.

Can a settlement agreement be withdrawn or rescinded?

If an agreement has not yet been signed by both parties and has therefore not been completed or become an open and binding agreement, it will still be without prejudice and subject to contract and can technically be withdrawn. However, this is a rare occurrence, as once an employer has made the effort and gone to the expense of getting a lawyer to draft a settlement agreement, they will not settle at any cost, but are likely to keep any original offer on the table at least until a realistic deadline has passed. If an agreement has completed and become an open and binding contract, it cannot be withdrawn. However, if there is a breach of warranty by an employee this may mean that an employer can claim payments made back as a debt, or if the breach is discovered before payment is made, an employer can validly not make certain payments under the agreement.

When can a settlement agreement be used?

A settlement agreement can be used in a variety of situations where an employer and employee wish to part company, or less commonly where employment will continue but an ongoing dispute is to be settled. A settlement agreement might be used as part of a redundancy exercise, performance management or long term sickness dismissal, to avoid having to carry out a potentially lengthy process and to avoid having to defend potentially expensive claims relating to these matters in an Employment Tribunal.

What are settlement payments?

Settlement payments (sometimes referred to as severance payments or termination payments) are sums paid to employees on termination of their employment or when settling a potential claim and might include damages for wrongful dismissal, alleged unfair dismissal or compensation for discrimination, as well as for statutory redundancy payments, payments into and out of pensions and ex gratia payments. These payments are generally made under a settlement agreement whereby an employee waives their right to bring employment claims in return for an agreed sum, or compensation. Generally, employers can pay the first £30,000 of compensation under the settlement agreement, tax free, but this will not apply to all payments.

Who is liable for any deductions required from settlement payments?

It is crucial to establish whether or not income tax and National Insurance Contributions (NICs) are owed on payments made on termination of employment. Different payments will attract different tax liabilities and if these have not been calculated and paid correctly HMRC will look to enforce payment where necessary, including any penalties for late payment and for inaccurate returns. HMRC will normally pursue the employer first, as it has the primary responsibility to account for tax and NICs (under PAYE) and the former employee will be entitled to a PAYE credit in his self-assessment tax return for the PAYE that should have been deducted. Only if HMRC decides the employee should bear the liability, will the employee be liable. The employer will always be responsible for unpaid employer NICs.

Settlement agreements generally include a specific tax indemnity so that one party, usually the employee, has the risk as to future tax to be deducted from the payment. However, even if there is no specific tax indemnity in the agreement, the employer can seek payment from the employee to the value of income tax paid by the employer on an employee’s behalf.

What is the tax treatment of settlement payments?

There are several different payments and benefits which might be received by an employee on the termination of their employment. These need to be assessed in all the circumstances to decide whether they are subject to statutory deductions or can be paid tax free.

Significant changes were made to how Payment In Lieu Of Notice (PILON) has been treated, since 6 April 2018, which has in some cases made payments and their tax treatment more complicated. It is wise to seek professional advice when looking at the taxation of termination payments, particularly in respect of PILON. Here are some of the more common payments and a guide to their tax treatment:

Type of paymentTax treatment
Salary and benefits up until the termination of employmentAll payments and benefits which relate to normal earnings during employment up until the termination of the employee’s employment, are subject to the usual PAYE deductions. This includes bonus entitlement and holiday pay for annual leave accrued and untaken up until the termination of employment. Any benefits such as health insurance which may continue after employment but in the same tax year, must still be taxed as earnings but the benefit will be apportioned and any which falls in the next tax year may fall under the £30,000 exemption, if this has not been exhausted by other payments made on termination.
Redundancy paymentsStatutory redundancy payments, for those employees who have two or more years of service, fall within the £30,000 exemption to tax. Any sum over £30,000 when redundancy payments and any other ex gratia payments are added together would attract tax. An enhanced redundancy payment is a relevant termination award and so does not automatically benefit from the £30,000 exemption. Where an employee must stay for a set period before being made redundant under a settlement agreement, HMRC may argue that part of the redundancy payment relates to a retention bonus (which is taxable as earnings and gives rise to both employer and employee NICs). Further, a payment made to an employee who chooses to retire on being made redundant may be considered by HMRC to be taxable as a benefit under an employer-financed retirement benefits scheme.

If you are unsure it is prudent to seek professional advice.
Ex gratia paymentsCompensatory, ex gratia payments made for loss of office or employment and paid over and above what an employee is entitled to under their contract of employment, are exempt from tax up to £30,000.

If the settlement agreement includes compensation that exceeds the £30,000 exemption, the employer should deduct tax at the OT tax code rate appropriate to the specific employee, which may mean making deductions at different rates from 20% to 45% depending on the size of the excess. For more advice on OT Codes either visit the tax codes section on the HMRC website or contact us.

Compensation payments are not earnings for NIC purposes and are exempt from NIC completely even if they exceed £30,000. From 6 April 2020 all termination payments above the £30,000 threshold are subject to class 1A NICs (employer liability only).
Payment In Lieu Of Notice (PILON)Since April 2018, any payment in lieu of notice must be treated as earnings and so is subject to tax and class 1 NICs. Unless an employee has worked their full notice period, a settlement agreement must clearly state the amount of the payment in lieu of notice due. The government has created a statutory formula that should be applied to ensure that any outstanding notice pay due is paid subject to tax and national insurance.
Post-Employment Notice Pay (PENP)The simplified formula for calculating PENP applies where an employee is paid monthly, and their contractual notice period is expressed in months and their employment is terminated immediately or their unworked period of notice is in complete months. The Finance Act 2021 provides for an alternative calculation for PENP, a standard (more complicated formula) applies if the employee is not paid monthly or their notice period or any unworked notice is not whole months. If an employee’s employment terminates and payments are received before 6 April 2021, this alternative formula can still be used if this would benefit the employee.
Payments for injury to feelings or for injury or disabilityWhere compensation has been paid for injury to feelings arising from unlawful discrimination before the termination, it will not be taxable. Where the injury to feelings was caused by the termination itself, compensation paid will be taxable. A payment can be made free of tax where it is on account of a disability or injury (and death). The payment must relate to the fact of the injury or disability and not the effect on earnings.
Payments for restrictive covenants and other obligations surviving the termination of employmentIf the employee’s employment contract contains enforceable restrictive covenants (for example, restricting an employee’s ability to solicit or deal with clients in competition with the employer), the employer will be able to rely on these provided they have not breached the employment contract. If the contract of employment does not contain valid and enforceable post-termination restrictions, the employer can seek new restrictions and will need to pay a token sum (consideration) as well as getting the employee to sign agreement to these, to make the new restrictions enforceable.

There may also be a confidentiality clause relating to confidential information learnt whilst employed by the employer, which the employee promises to keep confidential (whilst this information is not otherwise in the public domain). Additionally, there is confidentiality relating to how the employee’s contract has been terminated. These sums are subject to statutory deductions.
Pension paymentsEmployer contributions to registered and employer-financed retirement benefit schemes can be made tax free and will not use up any of the £30,000 tax free allowance if the payment is:

  • Part of an arrangement relating to the termination of the employee’s employment (such as a settlement agreement).

  • Made to provide benefits for the employee in accordance with the rules of the scheme.

  • Within the annual and lifetime allowances for contributions to registered pension schemes.

  • Not otherwise taxable.

  • Discussed between the employee and employer and it is agreed before the payment is made into the scheme that the employer has no right or discretion to make the PILON and the employee has no right to insist on it being paid. Any agreement to give up a contractual PILON should be made before employment ends or notice is given. Also, a period equal to at least the statutory minimum notice must remain as a PILON, that way an employer can still enforce post-termination restraints and confidentiality provisions, if required
  • Outplacement costsContributions to the cost of outplacement counselling to assist an employee leaving a job and searching for a new one, for example by way of relevant training, are not taxable. These costs should be paid directly by the employer and so do not count towards the employee’s £30,000 tax free threshold.
    Legal costsUsually, the employer pays a contribution towards the legal costs of the employee seeking independent legal advice on the terms and effects of a settlement agreement. This does not count towards the £30,000 exemption if it is solely in connection with termination of employment, is paid directly to the employee’s solicitor and a clause in the settlement agreement specifically states this.
    Share options and share awardsIf an employee has share options or share award entitlements before or after termination of their employment, you will need to look at the specific scheme document to see whether tax and NICs are due to be paid and in what amount. Under a settlement agreement it is likely that you would be considered a ‘good leaver’ under many share options schemes. A cash cancellation or compensation payment will be fully taxable.
    Money deducted from a settlement to write off loanThe writing-off of an employee loan by an employer on termination of that employee’s contract is not eligible for the £30,000 exemption, as it is taxable as earnings. Any income tax is not paid through PAYE. Instead, the employer reports the write-off to HMRC on form P11D (but class 1 NICs are due at the time of the write-off in the normal way). Therefore, in the best interests of the employee and employer, if the employer is proposing to write off the loan, the employee should pay off the loan and receive an ex-gratia payment instead, which may be eligible for the £30,000 exemption and will not be subject to NICs.
    Protective awardsOver £30,000 these are taxed under PAYE, but the first £30,000 of protective awards does not attract taxation. It is suspected that failure to inform and consult under TUPE is treated in the same way, but this has not been confirmed by HMRC.
    Variation of rights and payments to buy-out a benefit or other employment paymentWhere the employee gives up a right to a payment, the compensation paid will usually be taxable in the same way as the bought-out payment would have been taxed. If this did not apply, the payment would nevertheless be treated as earnings under the benefits code and so it is unlikely unless a change was truly fundamental that this would be tax free.

    What if the termination payments stagger a tax year?

    Most termination payments are made in one lump sum, but payments can be staggered or delayed. An employee may request for some of the payments to be made in a new tax year if they anticipate earnings will be less in the latter tax year.

    Settlement agreements and entitlements to state benefits

    Most individuals who find themselves out of work will now only be able to apply for the ‘new style’ Jobseeker’s Allowance. They will only be able to apply for contribution-based and/or income-based Jobseeker’s Allowance if they receive the severe disability premium or got the severe disability premium within the last month and are still eligible to receive this.

    To claim the ‘new style’ Jobseeker’s Allowance an employee must have been an employee and paid Class 1 NICs in the last few years. An employee would also need to be 18 or over (but under State Pension Age), not in full time education, able, legally entitled, and available to work but not working or working fewer than 16 hours per week. Employees will need to demonstrate that they are actively seeking work to continue receiving Jobseeker’s Allowance. The ‘new style’ Jobseeker’s Allowance is available if an employee is eligible for up to 182 days, but employees should also check whether they are entitled to universal credit which can be paid instead of or at the same time as Jobseekers’ Allowance.

    If you require more information about benefits in an employee’s specific circumstances, you should contact the Department for Work and Pensions or Citizens Advice Bureau.

    About our expert

    Simon Gilmour

    Simon Gilmour

    Partner and Head of Employment
    Simon is a Partner and Head of Employment at Harper James. He joined the firm in April 2018 as a partner in the employment team. Having qualified as a solicitor in 1994, he has worked at top 50 law firms in the West Midlands for 25 years, 18 of which were as a partner and Head of Department.

    What next?

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