A settlement agreement does not have its own tax rule: HMRC looks through it and taxes each element according to what it really pays for. Holiday pay, arrears of salary, bonuses and notice pay are fully taxable earnings; compensation for losing the job is taxable only above £30,000; legal fees paid directly to the employee’s lawyer are exempt; and injury to feelings is tax free only where it relates to discrimination before the termination.
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Why does the wording of a settlement agreement count?
A settlement agreement (formerly a compromise agreement) ends the employment and stops the employee bringing tribunal or court claims. Because it is a separate document, it is sometimes argued that everything paid under it is a termination payment within section 401 of the Income Tax (Earnings and Pensions) Act 2003. HMRC’s Employment Income Manual rejects this: EIM12855 says the agreement may well contain elements taxable under section 62 (earnings) or section 225 (restrictive undertakings), and CWG2 tells employers to treat each element separately and then add the results together.
EIM12965 says best practice is for the agreement itself to set out what each part of the payment relates to. Where a single sum is paid “in full and final settlement of all claims”, the facts are examined and a reasonable apportionment agreed, and where the agreement relates partly to the termination, the onus is on the taxpayer to show a payment is not connected with it. Clear drafting therefore saves argument later.
How are holiday pay, salary and bonuses taxed?
Accrued holiday pay, unpaid salary and commission, and bonuses due under the contract are earnings under section 62. They are taxed in full through PAYE and carry employee and employer Class 1 National Insurance. Calling them compensation in the agreement makes no difference. EIM12965 adds that compensation for pay the employee should have received during the employment, such as an equal pay shortfall, takes its character from the pay it replaces and is also earnings.
If these sums are paid after the P45 has been issued, CWG2 requires code 0T on a week 1 or month 1 basis, and National Insurance on irregular items such as accrued holiday pay is worked out using a weekly earnings period. The employee may need to reclaim overdeducted tax later; see claiming tax back after leaving a job.
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How is notice pay taxed?
A contractual payment in lieu of notice is earnings. Since 6 April 2018, even where there is no contractual PILON, sections 402A to 402E require the employer to calculate post employment notice pay (PENP) on the termination award, and that amount is fully taxable with Class 1 National Insurance. Only the balance above PENP can use the £30,000 threshold. Our guide to payment in lieu of notice and PENP sets out the formula. If the employee is on gardening leave and works out proper notice, the pay is simply salary.
How is compensation for loss of employment taxed?
An ex gratia payment for losing the job, enhanced redundancy pay, statutory redundancy pay and damages for unfair or wrongful dismissal fall within section 401. Section 403 taxes them only above £30,000, and all such amounts from the same employer and associated employers share one threshold. Employees pay no National Insurance on them, but the employer pays Class 1A at the secondary rate (15% for 2026 to 2027) on the excess over £30,000, reported in real time. The full rules are in our guide to tax on termination payments.
Is compensation for injury to feelings taxable?
It depends on what the feelings relate to. EIM12965 sets out HMRC’s approach:
- Discrimination during employment. If the payment can reasonably be attributed solely to discrimination, harassment or victimisation before the termination, it is not connected with the termination, falls outside section 401 and is not taxable.
- Discriminatory dismissal. If the termination itself was the discriminatory act, the payment is connected with the termination and falls within section 401. Section 406(2), in force from 6 April 2018, states that the injury exemption covers psychiatric injury but not injured feelings, so the payment is taxed above £30,000 with the rest of the section 401 amounts.
- Both. Where there was discrimination during the employment and a discriminatory dismissal, the payment is apportioned on the facts.
HMRC follows the Court of Appeal in Moorthy v HMRC that the amount attributed to injury to feelings must be proportionate to the Vento guidelines, applying the guidelines in force when the agreement is signed. Larger sums labelled as injury to feelings are likely to be challenged.
Compensation for a recognised psychiatric injury such as depression that prevents the employee doing the job can be fully exempt under section 406(1)(b), but HMRC expects medical evidence.
Are the employee’s legal fees taxable?
Settlement agreements usually include a contribution to the employee’s legal advice. Section 413A exempts the payment if it meets legal costs incurred exclusively in connection with the termination and either it is made under a court or tribunal order, or the agreement provides for the employer to pay and the money is paid directly to the employee’s lawyer. CWG2 confirms it is not included in gross pay for National Insurance. EIM13740 adds that the relief covers lawyers’ fees and disbursements, including expert witnesses instructed by the lawyer, but not other professional costs such as accountancy fees. A contribution paid to the employee personally does not qualify. The employer’s side of the costs is covered in our guide to deducting legal and professional fees.
What about restrictive covenants, waivers and pension contributions?
- Restrictive covenants. A sum paid for a new non compete, non solicitation or confidentiality undertaking is earnings under section 225 and carries Class 1 National Insurance (NIM02320). Simply confirming covenants already in the contract, with no separate payment, gives no charge (EIM03605).
- Waiver of claims. The employee’s promise not to sue is technically a restrictive undertaking, but EIM03606 explains that where no specific sum is attributed to it there is normally no charge, because the payment is fully attributed to the claims being settled. Attributing a figure to the waiver makes that figure taxable.
- Pension contributions. An employer contribution to a registered pension scheme under section 408 is not taxed and does not use the £30,000 threshold (EIM13735), provided any contractual cash entitlement was waived first.
- Outplacement counselling meeting the CWG2 conditions is not taxable.
How would a typical settlement be split?
Illustration only. A settlement agreement for an employee with 2 months’ unworked notice on £4,500 a month pays: £2,000 accrued holiday pay, a £40,000 termination payment, £6,000 for injury to feelings attributed to harassment during the employment, £750 paid directly to the employee’s solicitor, and £1,500 for a new six month non compete clause.
| Element | Tax | National Insurance |
|---|---|---|
| Holiday pay £2,000 | Taxable in full | Class 1 |
| PENP £9,000 (from the £40,000) | Taxable in full | Class 1 |
| Balance £31,000 | £1,000 taxable after the £30,000 threshold | Employer Class 1A on £1,000 |
| Injury to feelings £6,000 | Not taxable if attributable solely to pre termination conduct | None |
| Legal fees £750 | Exempt under section 413A | None |
| Restrictive covenant £1,500 | Taxable in full under section 225 | Class 1 |
Departing directors should also check their service contracts, since contractual entitlements are earnings however the agreement describes them.
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Related Accountapedia entries
- Employer NI on termination payments
- Restrictive covenant payments: tax and NI
- Paying someone after they have left: the 0T code
- Payroll when an employee dies
- Which expenses and benefits attract Class 1 NI
Sources
- GOV.UK: Manual page EIM12855
- GOV.UK: 2026 to 2027 employer further guide to paye and national insurance con
- GOV.UK: Manual page EIM12965
- legislation.gov.uk: Act 2003 c. 1, section 406
- GOV.UK: Manual page EIM13610
- GOV.UK: Manual page EIM13874
- GOV.UK: Manual page EIM12975
- GOV.UK: Rates and allowances national insurance contributions
- GOV.UK: Manual page EIM13530
- legislation.gov.uk: Act 2003 c. 1, section 413A
Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.