Settlement agreement with a tax-free payment

The first thirty thousand pounds of a termination payment can be paid free of income tax, which is why settlement agreements are structured the way they are and why employees ask for payments to be labelled compensation; but notice pay is taxed as earnings whatever the agreement calls it, bonuses and holiday pay are earnings, payments for covenants are earnings, and the excess over thirty thousand pounds bears tax and employer's national insurance. The agreement has to allocate each payment to the right category, apply the exemptions that exist (injury or disability, legal fees, outplacement, pension contributions), run the right amounts through payroll, and contain the tax indemnity that protects the employer if HMRC disagrees. I draft the agreement for the employer for a fixed fee of £795, delivered in three working days, with a note on the conversation; a version including negotiation with the employee's adviser is £995; the accountants confirm the treatment.

Who this is for

Employers in England and Wales negotiating a settlement where the employee has asked for a tax-free payment, and employers who want to know what can and cannot be paid without tax before they make an offer.

What matters in the tax of a settlement payment

What the thirty thousand pound exemption covers and what it does not

Sections 401 to 403 of the Income Tax (Earnings and Pensions) Act 2003 tax payments received in connection with the termination of employment, with the first thirty thousand pounds exempt, but only for payments that are not otherwise earnings: compensation for loss of employment, statutory and genuine enhanced redundancy payments, and damages for breach of contract where no pay in lieu clause applies; the exemption is per employment (one threshold across all payments on that termination, including any made later), and the agreement should allocate the compensation payment to the exemption, state that the employer applies it on the basis the agreement records, and leave the accountants to confirm, because an allocation that HMRC rejects is an under-deduction the employer pays.

Post-employment notice pay and why notice is always taxed

Since the rules in sections 402B to 402E of the Income Tax (Earnings and Pensions) Act 2003 came in, the part of a termination payment that represents notice the employee did not work (post-employment notice pay, calculated by the statutory formula from basic pay and the unworked notice period) is taxed as earnings and subject to national insurance whether or not the contract contains a pay in lieu clause and whatever the payment is called; the agreement should state the notice period, whether it was worked, served on garden leave or paid in lieu, and the resulting post-employment notice pay, so that the payroll can calculate it, and the employee's adviser should be told that no drafting avoids it.

The elements that are earnings whatever they are called

Salary to the termination date, accrued holiday pay under regulation 14 of the Working Time Regulations 1998, contractual bonus and commission, benefits in kind to the termination date, payments for new or reaffirmed restrictive covenants (taxed under section 225 of the Income Tax (Earnings and Pensions) Act 2003), and payments in return for continuing confidentiality where separately valued are earnings taxed through payroll with national insurance, and the agreement should list them separately from the compensation payment, because an agreement that rolls everything into one 'ex gratia' figure invites HMRC to treat the whole of it as earnings.

Injury, disability, legal fees and the other exemptions

A payment made on account of injury to, or disability of, the employee is exempt without limit under section 406 of the Income Tax (Earnings and Pensions) Act 2003 where it is made because the injury or disability has ended the employment (not for injury to feelings in a discrimination claim connected with termination, which falls within the ordinary rules); the employer's payment of the employee's legal fees for advice on the agreement is exempt under section 413A where paid direct to the adviser under the agreement's terms; outplacement and retraining costs are exempt under section 310 where the conditions are met; and an employer's contribution to a registered pension scheme is not a termination payment at all, which makes it a useful way to deliver value above thirty thousand pounds; the agreement should use each where it applies and the accountants should confirm.

National insurance, payroll and the employer's reporting

Termination payments above thirty thousand pounds bear employer's national insurance (though not employee's), the earnings elements bear both, and the employer must process the payments through payroll with the correct treatment, report them, and provide the employee with the tax documentation, which the agreement should say the employer will do; the agreement should also state when each payment is made (within a stated period after the termination date, or after the employee's adviser signs the certificate), because payments made in a later tax year or after the employment ends are treated under different rules and the timing is a payroll decision the agreement should fix.

The tax indemnity and the limits of what the employer can promise

The agreement should state that the employer will deduct tax and national insurance as it is required to by law, that it has applied the exemption on the basis the agreement records, and that the employee indemnifies the employer for any further tax, interest and penalties on the payments other than the amounts the employer was required to deduct; the employer cannot promise that a payment will be tax-free, because HMRC can disagree, and the agreement should say that no representation is made about the tax treatment and that the employee should take their own advice; a settlement that promises the employee a tax-free sum and is wrong leaves the employer paying the tax.

What it costs

Settlement agreement, £795. Drafted for your situation, with a note on how to have the conversation. Three working days.

Settlement agreement including reasonable negotiation with the employee's adviser, £995. The agreement in three working days. The negotiation then runs until the agreement is signed or it becomes clear it will not settle. Reasonable negotiation means what, in my experience, amounts to the standard back and forth on a settlement agreement. If the employee or their adviser is being unreasonable, for example by conducting themselves unprofessionally or requiring a substantial rewrite that needs material further legal advice to you, I will flag it and we will discuss how best to proceed, which may involve further fixed-fee work. That would be unusual.

Buying online forms the engagement on payment. The scope is what the settlement agreements for employers page describes, you accept the Terms of Service at checkout, and I email you within four working hours to get started. If you would rather ask something first, email me.

What you get

• A bespoke settlement agreement drafted for the exit you are dealing with
• Proper waiver of the relevant statutory claims, so the agreement does what you are paying for
• Advice on the tax treatment, including the £30,000 exemption and what falls outside it
• Confidentiality, non-derogatory statements and an agreed reference
• Reaffirmation or replacement of restrictive covenants, which is often the real value
• A short note on how to open the conversation and keep it without prejudice or protected
• One round of amendments after the employee's adviser responds

What is not included

• Advising the employee, which their own adviser must do independently for the agreement to be valid
• Tribunal representation if the matter does not settle
• Payroll processing of the settlement sums
• Handling the settlement payment, since I do not hold client money

Questions I am often asked

Can we pay the whole settlement as a tax-free compensation payment?

Not if part of it is notice, holiday, bonus, commission or a payment for covenants, which are earnings whatever the label. The compensation element uses the exemption; the agreement separates the rest.

The employee wants us to call the notice period 'compensation' so it is tax-free. Can we?

You cannot. Post-employment notice pay is taxed as earnings whatever it is called and whether or not there is a pay in lieu clause. The agreement calculates it so that the payroll deducts correctly.

Can we pay more than thirty thousand pounds without tax?

Through a pension contribution, the legal fees exemption, outplacement within the rules, or an injury or disability payment where the conditions are met. Otherwise the excess bears tax and employer's national insurance. The accountants confirm each.

Related guidance and services

• Settlement agreements for employers, £795, the service this page describes
• Employment contracts and handbooks, £595
• Shareholders agreement, £995
• Settlement agreement after a long-term sickness absence
• Settlement agreement on redundancy

This page is general guidance for businesses in England and Wales, not advice on your own circumstances. Last reviewed: October 2026. Email geoffrey@caesar.co.uk.