In this article we take a look at what an “ex-gratia” payment is, what sums under a settlement agreement generally are and are not taxed, and how you can make your settlement agreement most tax-efficient.
What is an “ex-gratia payment”?
An ex gratia payment is a payment made by an employer where there is no contractual obligation to do so – it is derived from the Latin: “out of kindness” (used to mean done as a favor and without legal obligation).
Ex gratia translates to ‘by favour’ and literally means a voluntary payment or a gift. In Settlement Agreements these payments indicate a sum that is paid without admission of liability by the employer and the use of the term ‘ex-gratia’ specifies to each party that the employer does not consider that they are under an duty to provide this amount.
Top 5 tips for employees
- You can ask for the first £30,000 of any ex-gratia payment to be paid tax-free;
- Statutory redundancy payments are always tax-free;
- You may be able to pay sums into your pension in a tax-efficient manner;
- Your employer will generally pay your costs for receiving legal advice; and
- It’s almost always worth at least trying to negotiate the value of the ex-gratia payment you’re being offered – you only get one shot at it!
Are ex gratia payments taxable?
Payments that are made between an employer and employee are normally subject to tax as they will be described as ‘arising out of the contract of employment’ by HMRC. Ex-gratia payments are an exception to that rule and fall under a tax exemption from s.403 Income Tax (Earnings and Pensions) Act 2003 for any amounts under £30,000.00. This is because the payments made are not made for the work that has been undertaken or for a provision of services; they are a “voluntary” payment made by the employer and are “compensation for loss of employment”.
Any ex-gratia payment over £30,000.00 should be reported to the Inland Revenue to ensure that there will be no unexpected tax liability in the coming year.
In terms of the way that payments are normally dealt with under a settlement agreement, the general rules are normally (although not always) followed:
- Paid free of tax: Ex-gratia payments and statutory redundancy payments
- Tax and national insurance to be paid: payments in lieu of notice, holiday pay, and normal contractual pay will be subject to tax and national insurance even when they are paid via a Settlement Agreement (and, if such is being paid, sums in respect of commission, bonus, equity schemes etc.)
Ex-gratia payments and Payments In Lieu Of Notice (“PILON”)
Until April 2018 it was possible to structure your settlement agreement so that you received your payment in lieu of notice tax-free. However, on 6 April 2018 new legislation was brought into force that now stops this from happening – employers must now account to HMRC for any payment made to an employee in respect of notice pay, so tax and national insurance deductions must be made.
Pensions and tax efficiency
Part of an arrangement relating to the termination of the employee’s employment;
Made in order to provide benefits for the person in accordance with the rules of the scheme; and
Not otherwise taxable, for example, as a contractual PILON
Paying sums into an employee’s pension scheme upon termination can be useful if the employee has used up the £30,000 tax-free amount for ex-gratia payments, as they can potentially pay any surplus into their pension scheme tax-free – for example, if an employee is receiving compensation for loss of employment (an “ex gratia payment”) of £40,000, then they could potentially receive the first £30,000 tax-free under section 403 ITEPA 2003, and they could potentially pay the remaining amount into their pension scheme under section 408 ITEPA 2003. However, this will depend on the circumstances and you should check your pension situation with your solicitor and accountant first, before making any decision about this.
Ex-gratia redundancy payments
Statutory and enhanced redundancy payments fall within sections 401 to 416 of ITEPA 2003, and can therefore be paid tax-free (up to a maximum of £30,000) – provided they are paid genuinely on account of redundancy.
There is no normally no legal obligation for employers to pay enhanced redundancy payment (see this article for an analysis of when an employee may be legally entitled to an enhanced redundancy payment) but such payments are normally made as a gesture of goodwill, to avoid legal action, and to ensure that the employment relationship is terminated as quickly as possible. For example, in a redundancy situation it might take your employer over a month to go through the formal redundancy process (whereupon you may be made redundant anyway), so most employers take the view that it’s worthwhile to pay the employee a months’ ex-gratia pay to save them the time and effort of the process.
Compensation for discrimination
If you have been discriminated against in the workplace then you may receive compensation for “injury to feelings” (i.e. the harm and upset you have suffered as a result of the distress you’ve suffered because of the discrimination). This normally, but not always, interlinks with a psychological injury that may have been sustained by the victim of the discrimination (for example, they may suffer from ‘stress and anxiety’ or depression, as a result).
So, can compensation for injury to feelings be paid tax-free? The answer is, as it is so often: “it depends”.
The general rule at the moment is: if an ex-gratia payment is made to an employee that payment relates to injury to feelings and the discrimination giving rise to the payment is not related to the termination of employment, it can be paid tax free; if it relates to the termination of employment then it may be classed as a ‘termination payment’ and therefore subject to tax.
As an extra layer of complication, in the Finance Act 2018 the Government introduced another category of tax-free employment-related payments: a “disability exemption” payment. A payment on account of an injury or disability is tax free under section 406 of ITEPA 2003 and free of NICs. However, you will need to prove that, as an objective fact, you have a relevant disability and, further, that the person making the payment is making it on account of your disability (and not because of the termination of your employment). The “disability exemption” payment has, in our experience, not been much-used thus far, but we can explore with you whether we can use such an exemption in your particular circumstances.
Tax indemnity clauses in settlement agreements
There may be a clause in your settlement agreement which is named a ‘tax indemnity clause’. Some of our clients become concerned about this clause, as they think it opens the door to potential tax issues in the future; this is particularly the case because, in a lot of situations, the relationship of trust and confidence between employer and employee has broken down and, frankly, the employee just wants to see the back of the employer.
Our general advice on these clauses is that there is normally nothing to worry about: they are standard clauses in settlement agreements and are used as a matter of custom and practice. Our experience is, further, that in the vast majority of cases there are no further tax issues once the employment has terminated and the settlement agreement has been completed.
We do recognise, however, that clients want to discuss such clauses and receive advice on them – we are, of course, more than happy to do that with all clients.
Can our settlement agreement solicitors help?
Take a look at our settlement agreements page: we can help you and often your employer will pay the fee.