Are Settlement Agreements Taxable?

A settlement agreement payment (lump sum) under £30,000 is not taxable. Payments under £30,000 are not taxable providing they do not include other contractual payments.


A settlement agreement payment may be referred to as “compensation payment”, “ex-gratia payment” or “termination payment”.


Payments can be classed as statutory or contractual.


The difference between contractual and statutory employment rights


Contractual rights are related to an employment contract. Statutory rights are governed by secondary legislation created in Parliament.


Any payment made by an employer to an employee in relation to their employment ending is classed as a ‘Termination Payment”. Termination payments are subject to tax laws.

Payment types and their Tax implications


Pension scheme contributions

Not subject to tax provided they fall within the statutory maximum payments

Pay in lieu of holiday


Pay in lieu of notice (PILON)


Owed salary and bonuses


Any other payments under the contract which are known as emoluments 


Compensation payment over £30,000


Redundancy payments

Most redundancy payments either contractual or statutory fall into the £30,000 compensation that can be paid to an employee tax-free.

Costs of legal services and advice

Not taxable as legal fees are covered by the employer

Tax implications on discrimination payments


Injury to feelings payments are paid in relation to discrimination awards or discrimination settlements. These payments may be made free of tax or National Insurance. 


Injury and disability payments will not be eligible for tax as long as the payment is in relation to the injury and not based on loss of earnings arising from the injury. Injury to feelings payments related to unlawful discrimination that happened before the termination of employment would not be eligible for tax. 


The reason for this is that, unlike payments of compensatory awards/loss of salary awards, these payments relate to pain and suffering and not payments which would otherwise have been taxed by the employer. 


They reflect the injury to feelings that the employee has suffered, rather than being a punitive payment or a penalty. 


It is different to a personal injury claim because no medical injury is required for this type of payment to be awarded.


Injury to feelings payments are based on the Vento guidelines for such payments deriving from case law. 


The current Vento bands are split into lower middle and upper and this depends on the severity of the injury suffered. 

Vento guidelines on injury to feeling payments


As of April 2023, these break down as follows: 


Lower band

£900 – £9,100

Middle band

£9,100 – £27,400

Upper band

£27,400 – £45,600.

Further implications on settlement agreement tax 


HMRC may require further tax to be paid where gross payments have been incorrectly made and further tax claims made to the employer by HMRC will be passed onto the employee. Most settlement agreements include an indemnity clause stating that your employer will not be eligible for any further tax contributions sought by HMRC at a later date.

How to minimise settlement agreement tax?


One of the most obvious ways to reduce the tax payable on settlement payments is to ensure that the notice period within the agreement is properly documented and if necessary worked in full. 


If an employee serves his notice (i.e. works this notice) or spends it on garden leave then this should be clearly documented in their settlement agreement. If it isn’t documented there is a risk that HM Revenue & Customs will deduct tax and NI from any sums attributable to that notice period. 


All sums outside of contractual payments (emoluments) are tax-free provided that they are less than £30,000. Any payments above this will be taxable. However, payments above that figure may be deemed tax-free if they can properly be regarded as payments directly into a pension scheme or alternatively a payment for injury to feelings. 


Payments made directly into a pension scheme will only be tax-free provided they are within the statutory limits applicable for pension payments. 


Is less tax paid on a redundancy payment?


Tax implications are the same regardless if the payment is received from a settlement agreement or a redundancy. However, legal fee contributions paid by an employer for redundancy are tax eligible whereas for a settlement agreement, they are tax-free.


Need advice on your settlement agreement payments?


An experienced legal professional will be able to advise you on any tax payment amounts as well as when they need to be paid. Although we can advise on tax-eligible payments, HMRC will ultimately dictate what tax payments you’re eligible to pay and when.


Contact us for advice on your settlement agreement.


Categories Tax