The taxation issues relating to termination payments is a crucial factor for both workers as well as business employers when each party is considering a compromise agreement. Each party would like to lessen any tax liability as well as wanting assurance that no future tax obligation will accrue. If the employer does not withhold taxes or National Insurance Contributions owing from the employee’s salary then the company is typically liable for these kinds of sums to Her Majesty’s Revenue and Customs (“HMRC”)

If the suitable terms is incorporated within the compromise agreement then the worker is normally liable for these kinds of payments. Each party will as a result desire clarityrelating to what could or could not possibly be subject to tax under the terms of the compromise agreement.

Payments subject to taxes in compromise agreements

The following payments are normally subject to tax in a compromise agreement:

  • The employee’s salary (including any earnings during gardening leave)
  • Any contractual bonus or commission
  • Contractual payments in lieu of notice (also known as Payment In Lieu of Notice (“PILON”))
  • Consideration for entering into restrictive covenants within a compromise agreement

The definition of the above mentioned four elements will be covered in future articles.

Payments not liable for tax in compromise agreements

The following payments will generally not be liable for tax in compromise agreements:

  • Non-contractual payments made because of the the termination of the employee’s contract of employment and/or redundancy. The employee can take the benefit of a £30,000 tax-free allowance (s.401 to 404A Income Tax (Earnings and Pensions) Act 2003 (“ITEPA 2003”)). This includes terminations relating to:
  1. Damages for wrongful dismissal and payments relating to damages
  2. Compensation for unfair dismissal
  3. Compensation for discrimination to compensate for financial loss in connection with the termination of the employee’s contract of employment
  4. Payments of statutory and contractual redundancy pay
  • Non-contractual benefits in kind given by the employer upon termination of the compromise agreement
  • The contributions of the employer to registered pension schemes. This is tax-free subject to an annual contribution limit of (generally) £50,000. However, the position can be relatively complex).

Other miscellaneous payments:

  • Legal fees in connection with the compromise agreement
  • Outplacement counselling for the employee
  • Retraining of the employee

There may also be more complicated issues that may need expert advice relating to their tax treatment, including the payment of share options and share awards, if applicable.

Practical strategies for compromise agreements

Employers will frequently attempt to place the burden of any tax payment on the employee or worker in a compromise agreement. This is normally achieved by inserting an express contractual term concerning this in the compromise agreement. Whether this express contractual term actually alters the legal position (that the employer is liable for tax and National Insurance Contributions) is dependent upon the facts of the particular case. In the vast majority of situations, the practical issues relating to compromise agreements will mean that this kind of clause is usually included. However, the utilization of such terms (i.e. the employee being made liable for any tax relating to payments in the compromise agreement) is relatively rare so it isn’t normally a “make or break” issue in compromise agreements.


Redmans Employment Team deal with employment matters for both employers and employees, including drafting employment contracts and policies, advising employers and employees on compromise agreements, handling day-to-day HR issues, advising on restructures, and handling Employment Tribunal cases for both employers and employees

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