What is Settlement Agreement (Tax Treatment)?

Full Definition

A settlement agreement is a legally binding contract, most often used to end an employment relationship on agreed terms, under which the employee agrees to waive their right to bring specified employment tribunal claims (such as unfair dismissal or discrimination) in return for a payment and, usually, an agreed reference and other terms such as confidentiality. For a settlement agreement to be legally valid and binding on the employee's statutory claims, the employee must receive independent legal advice from a qualified adviser before signing, and the employer conventionally contributes a fixed sum -- commonly a few hundred to around a thousand pounds -- toward the employee's legal fees for that advice. The tax treatment of the total sum paid under a settlement agreement is not uniform: normal contractual entitlements such as outstanding salary, accrued but untaken holiday pay, contractual bonuses, and any Post-Employment Notice Pay (PENP) representing unworked notice are all fully taxable as earnings, subject to both income tax and National Insurance in the ordinary way, however they are labelled in the agreement. Only the genuine compensation-for-loss-of-employment element -- typically an uplifted or ex-gratia payment beyond what the employee was already contractually owed -- can potentially benefit from the £30,000 termination payment tax exemption, with employer (but not employee) National Insurance due on any part of that qualifying element above £30,000; the settlement agreement should itemise the different components clearly, since HMRC is not bound by how the parties choose to describe a payment if its true nature is different. Worked example: an employee agrees a settlement with their employer comprising £2,000 unpaid salary and bonus, £6,000 PENP for two months' unworked notice, and a £25,000 ex-gratia compensation payment, totalling £33,000; the £2,000 and £6,000 are fully taxable as earnings with income tax and both employee and employer National Insurance applied as normal, while the £25,000 ex-gratia element is a genuine termination payment falling entirely within the £30,000 tax-free exemption, so no income tax or employee National Insurance is due on it, though the employer must still account for Class 1A National Insurance if the qualifying termination element itself had exceeded £30,000.

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