Tax on Court Settlements and Compensation Payments UK 2026/27

The Core Principle: What Is the Payment For?

The taxability of a court settlement or compensation payment in the UK depends primarily on what the payment is compensating for. HMRC applies a fundamental principle: if a payment is a substitute for something that would have been taxable (such as earnings), it is taxable. If it compensates for a personal injury, a non-economic loss, or another non-taxable wrong, it may be exempt.

This principle applies equally to:

• Payments made under a court order following litigation
• Out-of-court settlements agreed between parties
• Employment tribunal awards
• Payments made under compromise agreements (now called settlement agreements)
• Insurance payouts following a legal claim

The tax treatment is determined by the nature of the payment, not by how it is labelled in the settlement agreement.

Personal Injury Compensation: The Exempt Category

The most clearly exempt category of compensation is money received for personal physical injury. Section 731 of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA) provides a complete exemption from income tax for:

• Compensation for personal injury to the claimant
• Compensation for the death of another person

This exemption applies whether the payment is:

• Ordered by a court following a contested hearing
• Agreed in an out-of-court settlement
• Paid by an insurer under a liability policy
• Structured as a lump sum or as a periodical payment (structured settlement)

There is no financial limit on this exemption. A GBP10 million award for catastrophic personal injury is fully exempt.

What Counts as Personal Injury?

The exemption covers physical personal injury. It also extends to psychiatric injury if it was caused by a specific traumatic event or an identifiable clinical condition. General stress, dissatisfaction at work, or anxiety that does not amount to a clinical disorder is less clearly covered by the exemption.

HMRC has accepted that payments for psychiatric conditions arising from workplace bullying or harassment can qualify for the personal injury exemption, but the medical evidence for the condition must be clear.

Interest on Personal Injury Awards

When a court awards damages for personal injury, it may also award interest on the damages to reflect the delay between the injury occurring and the payment being received. The tax treatment of this interest is generally taxable as income -- the interest does not inherit the exempt status of the underlying damages.

However, there is an exception where interest forms part of a structured settlement under a specific court order. In those circumstances, the interest element may also be exempt.

Termination Payments: The GBP30,000 Exemption

When employment ends, payments made to the departing employee may be exempt from income tax and National Insurance up to a threshold of GBP30,000. This exemption is widely known but frequently misapplied.

The exemption at section 403 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) applies to payments that:

• Are made in connection with the termination of employment
• Are not otherwise taxable as earnings
• Are not PILON (see below)
• Are not amounts due under the employment contract

Payments that qualify include:

• Statutory redundancy pay (which falls within the GBP30,000 exemption)
• Enhanced redundancy pay up to the GBP30,000 threshold
• Ex gratia payments made as a gesture of goodwill on termination, not under contractual obligation
• Certain compensation payments ordered by an employment tribunal for unfair dismissal

The first GBP30,000 of qualifying termination payments is completely exempt from income tax and from both employee and employer National Insurance. Amounts above GBP30,000 are subject to income tax at the employee's marginal rate and employer NI at 13.8%.

PILON: Payment in Lieu of Notice

One of the most commonly misunderstood areas is payment in lieu of notice (PILON). Many people assume PILON falls within the GBP30,000 termination payment exemption. It does not.

PILON is always taxable as earnings, regardless of whether the employment contract includes a PILON clause, and regardless of how the payment is described in the settlement agreement.

Since April 2018, the rules have been clarified and strengthened through the post-employment notice pay (PENP) rules.

The PENP Formula

The PENP rules require employers to calculate a specific amount of any termination payment that relates to the employee's notice period and tax it as earnings. The basic formula is:

PENP = (BP x D) / P

Where:

• BP = the employee's basic pay in the last pay period before the termination date (or before notice was given)
• D = the number of days in the notice period that was not worked
• P = the number of days in the last pay period

The PENP amount is taxed as employment income. Only the amount of the overall termination payment that exceeds the PENP (and which is also a genuinely compensatory payment rather than contractual pay) can potentially benefit from the GBP30,000 exemption.

Why the PENP Rules Matter

If an employer agrees to pay GBP50,000 as a termination payment and the employee had a three-month notice period they did not work, the PENP rules will carve out an amount equivalent to approximately three months' pay and tax it as income. Only the remaining amount (above PENP) can benefit from the GBP30,000 exemption.

Failing to apply PENP correctly can result in HMRC recovering unpaid PAYE from the employer, with interest and potential penalties.

Employment Discrimination Awards

Employment tribunal awards for discrimination (sex, race, disability, age, and so on) are among the most complex from a tax perspective. The reason is that discrimination awards can include multiple heads of loss:

1. Injury to Feelings

Awards for injury to feelings (sometimes called Vento bands, after the case that established the bands) compensate for the distress and humiliation caused by discriminatory treatment. These are not compensation for personal physical injury.

HMRC's position is that injury to feelings awards are taxable unless they relate to a psychiatric injury (a genuine clinical condition caused by the discrimination). However, some specialist tax advisers argue that well-founded psychiatric injury-based discrimination claims can attract the personal injury exemption.

In the absence of clinical evidence of a psychiatric injury, HMRC will seek to tax injury to feelings awards. However, amounts below GBP30,000 awarded as part of a settlement may fall within the termination payment exemption if the overall settlement also includes a termination element.

2. Loss of Earnings

Where a discrimination award includes past or future loss of earnings, this element is always fully taxable as employment income. Courts and tribunals will often gross up the award to reflect the tax that will be due, ensuring the claimant receives the intended net amount.

3. Aggravated or Exemplary Damages

Awards of aggravated or exemplary damages in discrimination cases are generally taxable as the equivalent of earnings rather than as compensation for a specific non-taxable loss.

Personal Data Breach and GDPR Compensation

Compensation received for data protection breaches under the UK GDPR is increasingly common. HMRC's position is that compensation for distress caused by a data breach (without accompanying physical or clinical psychiatric injury) is taxable. However, this area is developing and professional advice should be sought for larger awards.

Workplace Injury Caused by Employer Negligence

Where an employee suffers a physical injury at work and sues their employer for negligence, the compensation award follows the personal injury exemption rules. It is exempt from tax regardless of whether it includes an element for loss of earnings (past or future), because the entire award flows from the personal injury.

This is one of the few circumstances where compensation for loss of earnings is exempt from tax -- because it is an integral part of a personal injury award.

Defamation and Reputation Awards

Damages received in defamation cases are generally exempt from income tax and CGT where they compensate for damage to reputation or personal distress. However, if a defamation settlement includes an element for loss of business income (for example, where a professional's reputation was damaged causing loss of clients), that business income element may be taxable.

Inheritance and Estate Claims

If you receive a payment following a dispute over an inheritance -- for example, a family settlement resolving a contested will -- the payment is generally treated as capital. It is not income and is not subject to income tax. CGT may apply if the payment involves the disposal of chargeable assets, but a cash settlement to resolve a claim is typically not a chargeable event in itself.

Practical Steps When Receiving a Settlement

Request a tax breakdown in the settlement agreement. Employment solicitors routinely include an apportionment of the settlement between different heads (for example, GBP20,000 for loss of earnings, GBP10,000 for injury to feelings, GBP15,000 for compensation for the notice period). This breakdown is important for tax purposes.

Do not assume all personal injury compensation is straightforward. Where psychiatric injury is part of the claim, ensure the medical evidence is in order to support an exemption claim.

Apply PENP correctly if you are an employer. Incorrect treatment of PILON is one of the most common payroll compliance errors and can result in significant PAYE liabilities.

Keep records of what each element of a settlement represents. HMRC may enquire into a settlement payment, particularly where no PAYE was operated.

Consider taking specialist tax advice for any settlement above GBP30,000 or where the tax position is not clear-cut.

Summary

The tax treatment of court settlements and compensation in the UK depends on the nature of each element of the payment. Personal injury compensation is exempt from income tax and CGT with no limit. The first GBP30,000 of a genuine termination payment is exempt from income tax and NI, but PILON is always taxable as earnings under the PENP rules. Employment discrimination awards require careful analysis: injury to feelings may be taxable unless it flows from a genuine clinical psychiatric injury, while loss of earnings is always taxable. Professional advice is essential for larger or complex settlements.