How is a settlement agreement taxed in the UK?

Full answer

A settlement agreement (formerly called a compromise agreement) is a legally binding contract between an employer and employee that settles employment claims. The tax treatment depends on the nature of each payment within the agreement. **The £30,000 exemption** Genuine termination payments — including statutory and enhanced redundancy pay, ex-gratia payments, and compensation for loss of employment — qualify for a £30,000 tax-free threshold under s401 ITEPA 2003. Amounts above £30,000 are subject to income tax at your marginal rate. Crucially, employee and employer NI does not apply above the £30,000 threshold (unlike normal earnings). **Pay in Lieu of Notice (PILON)** Since April 2018, all PILONs are fully taxable as earnings, regardless of whether the contract contains a PILON clause. HMRC calculates the "Post-Employment Notice Pay" (PENP) and taxes it as earnings (income tax + NI), with any excess qualifying for the £30,000 exemption. **Compensation for injury to feelings** Payments for injury to feelings in a discrimination claim can be tax-free if they genuinely compensate for the discrimination and are not a disguised termination payment. Legal advice and HMRC clearance is recommended for significant sums. **Holiday pay, bonuses, commission** All fully taxable as earnings in the usual way — they cannot shelter under the £30,000 exemption. **Worked example** Employee receives: PILON £5,000 (taxable), enhanced redundancy £40,000. Tax: PILON £5,000 fully taxed; redundancy £30,000 tax-free, £10,000 at 40% = £4,000 tax. Employer pays no NI on the £40,000 redundancy element.

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