Answers · UK 2025/26

Are payments for a restrictive covenant in a settlement agreement taxable?

Yes -- a specific payment made in return for the employee agreeing to a restrictive covenant (such as a non-compete or non-solicitation clause) is always taxed in full as earnings, subject to Income Tax and National Insurance, and cannot fall within the separate £30,000 tax-free termination payment threshold, regardless of how the rest of the settlement is structured.

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Restrictive covenant payments are one of the most commonly misunderstood elements of a settlement agreement, because employees sometimes assume any payment linked to leaving employment can share in the £30,000 tax-free allowance -- but covenant payments are treated as a special, fully-taxable category by specific anti-avoidance legislation. **Why covenant payments are always taxed as earnings** Specific tax rules (rather than general termination payment rules) apply to any payment made in return for the employee entering into, or agreeing to be bound by, a restrictive covenant -- such as a promise not to compete with the former employer, not to solicit clients or staff, or not to disclose confidential information for a defined period after leaving. These payments are deemed to be earnings from the employment and taxed in full through PAYE, with no tax-free element available, however the payment is labelled in the agreement. **Why the legislation is drafted this way** Without this specific rule, employers and employees might be tempted to inflate the "covenant payment" portion of a settlement (perhaps disguising what is really just extra severance pay as a payment for a covenant) purely to try to route more of the total settlement outside the ordinary earnings/termination payment tax rules. The legislation removes any incentive to do this by taxing covenant payments as earnings regardless. **How it interacts with the rest of the settlement** A settlement agreement often has multiple distinct elements: normal notice pay or PILON (fully taxed as earnings), a genuine ex-gratia termination payment (potentially benefiting from the £30,000 threshold), a payment for the specific legal advice on the agreement (tax-free, as covered separately), and, if applicable, a specific restrictive covenant payment (fully taxed as earnings). Each element is assessed under its own rule -- the covenant payment does not reduce or share the £30,000 threshold available to the genuine termination element, but it is also not exempt itself. **Worked example** A sales director's settlement agreement includes: £8,000 PILON (taxed as earnings, since her contract had a PILON clause), £40,000 ex-gratia termination payment (first £30,000 tax-free, remaining £10,000 taxed as earnings under the excess-over-threshold rules, though NOT subject to employee NI, only employer Class 1A NI on amounts above £30,000), £15,000 specifically for agreeing to a 12-month non-compete and non-solicitation covenant (taxed in full as earnings, both Income Tax and full employee/employer Class 1 NI), and £700 legal fees paid direct to her solicitor (tax-free). Only the £30,000 slice of the termination payment escapes tax and NI entirely; every other element is taxed, just under slightly different specific rules. **Practical tip** When negotiating a settlement agreement, it is worth understanding that labelling more of the settlement as a "covenant payment" does not create any tax advantage over labelling it as ordinary ex-gratia termination pay (in fact it is worse, since covenant payments lose access to the £30,000 threshold) -- so from a purely tax-efficiency perspective, employees should generally prefer maximising the genuine ex-gratia termination element up to £30,000 rather than accepting more of the settlement structured as a covenant payment.