When you receive a settlement agreement payment, not every element is treated the same way by HMRC. Getting the tax treatment right matters — both for what you receive and for your employer's obligations. This guide explains the key rules for employees in England and Wales.
The £30,000 Tax-Free Threshold
The most important rule is that the first £30,000 of a genuine termination payment — often called an ex-gratia payment — is free from income tax and National Insurance. This is the amount your employer pays you over and above any contractual entitlements, as compensation for the loss of your employment. It does not include salary, holiday pay, or notice pay.
The £30,000 threshold applies to the ex-gratia element only. Contractual payments — including salary arrears, accrued holiday pay, and payment in lieu of notice (PILON) — are always taxable as income, regardless of how they are labelled in the agreement.
Payment in Lieu of Notice (PILON)
Since April 2018, all payments in lieu of notice are taxable as employment income, regardless of whether your contract contains a PILON clause. HMRC requires employers to calculate the 'post-employment notice pay' (PENP) and deduct income tax and National Insurance accordingly. This change closed a loophole that previously allowed some PILON payments to be paid tax-free.
The Bucket System
A useful way to think about settlement payments is the 'bucket' system. Bucket one contains taxable payments: salary, holiday pay, PILON, and any contractual bonuses. Bucket two contains the ex-gratia compensation — the amount paid purely to settle potential claims. Only bucket two benefits from the £30,000 exemption. Your solicitor will review how the agreement allocates payments between these categories.
Injury to Feelings Payments
If your settlement agreement includes a payment for injury to feelings — typically in discrimination cases — the tax treatment depends on whether the injury is physical or psychiatric. Payments for a diagnosed psychiatric injury caused by discrimination may be tax-free. Payments for general injury to feelings in non-discrimination cases are taxable. This is a nuanced area and your solicitor will advise on the specific position.
Structuring Payments for Tax Efficiency
In some cases, it is possible to structure a settlement payment to maximise the tax-free element — for example, by ensuring the ex-gratia payment is clearly separated from contractual entitlements, or by making contributions to a pension scheme (which may be exempt from both income tax and National Insurance). Your solicitor can advise on whether any structuring is appropriate in your circumstances.
Employer Contributions to Legal Fees
Employers typically contribute to the employee's legal fees as part of the settlement. This contribution is usually paid directly to the solicitor and is not treated as taxable income in the employee's hands, provided it is a genuine contribution to the cost of independent legal advice on the settlement agreement.
Always ask your solicitor to confirm the tax treatment of each element of your settlement payment before you sign. Once the agreement is executed, it is very difficult to revisit the allocation.