UK Settlement Agreement Tax Treatment 2026: What is Taxable?

Settlement agreements are used to resolve employment disputes and bring employment to an end. They often involve a lump sum payment to the employee. The tax treatment of that payment is not straightforward -- different elements are taxed in different ways, and the rules changed significantly in 2018. Understanding what is and is not taxable can mean thousands of pounds of difference.

The £30,000 Tax-Free Exemption

Many employees are told they can receive up to £30,000 tax-free when their employment ends. This is broadly correct, but with important conditions.

Under section 403 of ITEPA 2003, the first £30,000 of a termination payment is exempt from income tax, provided it meets the following conditions:

• The payment is made in connection with the termination of employment
• The payment is not an amount that would otherwise be treated as earnings (i.e., it is not contractual pay)
• The payment is not holiday pay, notice pay, bonus or other contractual entitlement

Above £30,000, the excess is taxed as income. It is also subject to employer's National Insurance (Class 1A) but not employee's National Insurance -- this changed in April 2020 following the introduction of the PENP rules.

What Is PENP?

PENP stands for Post-Employment Notice Pay. It was introduced to prevent tax avoidance through the manipulation of termination payments. The PENP rules mean that even where an employer does not have a contractual PILON clause, they must calculate and tax the portion of any termination payment that represents the unworked notice period.

The PENP Formula

PENP = (BP / D) x T - L

Where:

• BP = basic pay in the last pay period before the trigger date (the date notice is given or employment terminates)
• D = the number of days in that last pay period
• T = the number of days of the post-employment notice period (the statutory or contractual notice period that was not worked)
• L = the amount of any payment already made to the employee that is already taxable as earnings for the notice period

The result is the PENP amount -- the element of the termination payment that must be treated as earnings and is subject to both income tax and National Insurance.

PENP Example

Sarah's contract has no PILON clause. She is dismissed immediately. Her monthly salary is £4,000. Her contractual notice period is 3 months (90 days). She receives a total termination payment of £25,000.

• BP = £4,000 (last monthly pay)
• D = 30 (days in last pay period)
• T = 90 (days of unworked notice)
• L = £0

PENP = (£4,000 / 30) x 90 - £0 = £12,000

So £12,000 of Sarah's £25,000 payment is taxable as earnings (PAYE + NI). The remaining £13,000 falls within the £30,000 exemption.

Payments in Lieu of Notice (PILON)

If the Contract Contains a PILON Clause

If the employment contract expressly provides for a payment in lieu of notice, any PILON payment is treated as contractual earnings from the outset. It is fully taxable as income and subject to both income tax and employee/employer National Insurance. The PENP formula still applies, but it effectively confirms that the entire PILON amount is taxable.

If the Contract Does Not Contain a PILON Clause

If there is no contractual PILON clause and the employer simply pays money instead of allowing the employee to work notice, the PENP formula determines how much is taxable as earnings. Any excess above the PENP amount can potentially use the £30,000 exemption.

What Is Always Fully Taxable?

Certain elements of a settlement agreement are always taxable as earnings and cannot benefit from the £30,000 exemption:

Accrued holiday pay: Any payment for untaken statutory or contractual holiday entitlement is earnings. It is taxable as income and subject to National Insurance.

Contractual bonuses: If the employee is owed a bonus under their contract, it remains taxable even if paid as part of a settlement. The same applies to commission.

Garden leave pay: If the employee is placed on garden leave and receives their normal salary during this period, the payments are taxable as earnings in the usual way.

Restrictive covenant payments: Payments made in exchange for the employee agreeing not to compete or not to solicit clients are fully taxable as income.

Benefits in kind: The value of any non-cash benefits provided as part of a settlement (such as continued use of a company car) may need to be declared.

What Can Benefit from the £30,000 Exemption?

The following types of payment can potentially use the £30,000 exemption (subject to the PENP calculation first):

• Ex-gratia payments -- payments made purely as a goodwill gesture, not required by contract
• Compensation for loss of employment -- amounts paid to compensate the employee for losing their job
• Statutory redundancy pay -- always goes into the £30,000 exemption

Statutory redundancy pay itself counts towards and is included within the £30,000 limit. It is not in addition to it.

Injury to Feelings Payments

Compensation for injury to feelings (for example, in a discrimination claim) has complex tax treatment:

• In an employment context, HMRC's position is that injury to feelings awards are taxable as earnings if they arise from the employment relationship
• Awards made purely for injury to health (a distinct concept from injury to feelings) may be exempt
• This is a grey area -- legal advice is essential in cases involving discrimination or harassment claims

Tax on Amounts Above £30,000

Any part of the tax-free element that exceeds £30,000 (after setting off PENP and contractual elements) is taxable as income at the employee's marginal rate:

• 20% basic rate (income £12,571 to £50,270)
• 40% higher rate (income £50,271 to £125,140)
• 45% additional rate (income above £125,140)

The employer must deduct income tax through PAYE. For the portion above £30,000, the employer should use the employee's current tax code. If the employee has multiple income sources or complex tax affairs, HMRC may issue an OT code to avoid under-deduction.

Employer's National Insurance

From April 2020, employer's Class 1A National Insurance applies to the taxable element of termination payments above £30,000 (the non-PENP, non-contractual element). The PENP element itself is subject to Class 1 National Insurance (both employer and employee).

Employees do not pay National Insurance on the element that is taxed under section 403 (the excess above £30,000 after PENP). This is an important distinction.

Reporting and Self Assessment

Employer's obligations: The employer must report and deduct PAYE and NI on all taxable elements of the settlement through the real time information (RTI) system. The P45 must reflect the correct figures.

Employee's obligations: If the settlement agreement is complex, or if the total income in the year is significant, the employee may need to complete a self assessment return. HMRC may also issue a simple assessment for termination payments that were incorrectly taxed.

Timing: The tax point for a termination payment is generally the date it is paid. If the payment straddles tax years, splitting could have advantages (for example, if the employee will be a lower rate taxpayer the following year), but both parties must agree.

Frequently Asked Questions

Is the £30,000 tax-free limit per job or per year? It is per termination -- it applies to the total package of payments made in connection with a single termination of employment. If you have multiple jobs that end in the same tax year, each termination has its own £30,000 limit.

Does National Insurance apply to the £30,000 exempt amount? No. Employee's National Insurance does not apply to the tax-exempt portion of a termination payment (amounts that benefit from the £30,000 exemption under section 403). However, employer's Class 1A NI applies to any taxable excess above £30,000 that is not subject to Class 1.

What is the difference between PILON and PENP? PILON (payment in lieu of notice) is the payment itself -- money given instead of working the notice period. PENP is the formula used to determine how much of any termination payment represents that notice pay. PENP applies even where there is no contractual PILON clause.

Can I negotiate the tax treatment in a settlement agreement? The tax treatment is set by law -- you cannot agree with your employer to make a taxable payment tax-free. However, how the payment is characterised and structured can affect which tax rules apply. Legal advice from an employment solicitor and tax specialist is important.

Do I pay tax on statutory redundancy pay? Statutory redundancy pay counts towards and is included within the £30,000 exemption. It is not in addition to it. If your statutory redundancy pay is, say, £8,000, you have £22,000 of remaining exemption available for other qualifying payments.

What if my employer uses the wrong tax code when making the payment? You should receive a P45 showing the correct figures. If too little tax has been deducted, HMRC will collect the shortfall, usually through your next year's tax code or self assessment. If too much has been deducted, you can reclaim the overpayment from HMRC.

Is compensation for unfair dismissal tax-free? Compensation for unfair dismissal (the basic award mirrors redundancy pay, the compensatory award compensates for financial loss) can benefit from the £30,000 exemption for the genuine compensation element. The basic award is treated like redundancy pay. However, PENP and contractual elements must be identified first.

Does the PENP formula use contractual notice or statutory notice? PENP uses the longer of statutory notice (under the Employment Rights Act 1996) and contractual notice. If your contract gives you 3 months' notice and statute requires only 8 weeks, PENP uses 3 months.

What happens if a settlement payment is made in instalments? Each instalment is taxed at the point it is paid. The £30,000 exemption applies to the total package, not to individual payments. The employer should be careful to ensure PAYE is correctly operated on each instalment.

Should I get independent legal advice before signing a settlement agreement? Yes -- and in fact, a settlement agreement is only legally valid if you have received independent legal advice from a qualified adviser (usually a solicitor). Many employers contribute to or pay for this advice as part of the settlement. This is the opportunity to check the tax treatment of all elements before agreeing.