Money & Financial Issues

Will I Pay Tax?

One of the most common concerns employees have after receiving a Settlement Agreement is:

“Will I have to pay tax on the money I’m receiving?”

The answer depends on what the payment is for.

A Settlement Agreement often includes several different types of payments, and each may be treated differently for tax purposes. Some payments are normally subject to Income Tax and National Insurance, whilst others may qualify for more favourable tax treatment.

Understanding how your settlement is structured is important, as it can make a significant difference to the amount you ultimately receive.

There is no single answer

Many people assume that either the whole settlement is tax-free or the whole amount is taxable.

Neither assumption is necessarily correct.

A Settlement Agreement may include payments for:

• Salary.
• Notice pay.
• Holiday pay.
• Bonus or commission.
• Compensation for the termination of employment.
• Pension contributions.
• Other contractual entitlements.

Each payment should be considered separately when determining its tax treatment.

Compensation payments

Some compensation payments made in connection with the termination of employment may qualify for favourable tax treatment.

However, the rules are detailed and depend upon the nature of the payment and the circumstances in which it is made.

Simply describing a payment as “compensation” within a Settlement Agreement does not automatically determine how it will be treated for tax purposes.

Your solicitor can explain how the payment has been structured and identify any issues that may require further advice.

Notice pay

Notice pay is one of the areas that frequently causes confusion.

If you are entitled to receive notice pay under your contract of employment or because of the way your employment comes to an end, that payment will often be subject to Income Tax and National Insurance.

The way notice pay is calculated can be complex, particularly where payments are made in lieu of notice.

Understanding how your employer has calculated this element of the settlement is an important part of reviewing the agreement.

Holiday pay, salary and bonuses

Payments representing earnings are normally treated in the same way as they would have been during your employment.

This commonly includes:

• Outstanding salary.
• Accrued but untaken holiday pay.
• Bonus payments.
• Commission.
• Other contractual earnings.

These payments are generally subject to the usual deductions required by law.

What about pension contributions and benefits?

If your Settlement Agreement deals with pension arrangements, share schemes, private medical insurance or other employee benefits, the position will depend on the relevant contractual arrangements and the terms of the agreement.

It is important that these provisions are reviewed carefully so that you understand:

• What benefits will continue.
• Which benefits will end.
• Whether any further action is required before your employment ends.

Can the tax treatment be negotiated?

In some cases, the structure of a Settlement Agreement may be discussed as part of wider negotiations.

However, neither you nor your employer can simply decide how a payment should be taxed.

The tax treatment of each payment will depend upon the applicable legislation and HM Revenue & Customs guidance.

Any negotiations should therefore be conducted carefully to ensure that the agreement accurately reflects the legal position.

Why legal advice is important

Reviewing the tax provisions within a Settlement Agreement is an important part of the advice your solicitor will provide.

We’ll explain:

• What each payment represents.
• Which payments are likely to be subject to deductions.
• Any areas that require clarification.
• Whether the agreement appears to have been drafted appropriately.

Where specialist tax advice is required beyond the scope of the Settlement Agreement itself, we’ll explain this clearly so that you can make informed decisions before signing.

Avoid making assumptions

Many misunderstandings arise because employees hear that “Settlement Agreements are tax-free.”

The reality is more nuanced.

The tax treatment depends upon the individual payments included within your agreement rather than the document as a whole.

Obtaining independent legal advice ensures you understand exactly how your settlement has been structured and helps avoid unexpected surprises after the agreement has been completed.

Speak to a Specialist Solicitor

If you’ve received a Settlement Agreement and would like to understand how the payments within it are likely to be treated for tax purposes, Pepperells can help.

Our specialist Employment Solicitors will explain the financial provisions of your agreement in clear, straightforward language, answer your questions and ensure you understand the implications before you sign.

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