Settlement agreements

Settlement Agreements (formally called Compromise Agreements) provide a mechanism for the early termination of employment and a tax and N.I. free payment of up to £30,000 in compensation for loss of office. It should be noted that payments in lieu of notice (PILON) are treated as 'emoluments arising out of employment' and are therefore subject to deductions for tax and National Insurance.  Since 6th April 2018, the proportion of any amount paid under a Settlement Agreement that can equate to the amount the amployee would have been entitled to during his or her notice period will be treated as such an emolument regardless of whether there is a provision for the payment of a PILON in his or her Contract of Employment. 

The agreement typically takes the form of a 'without prejudice' letter from the employer to the employee that becomes an 'open' letter when it has been signed by both parties. Key considerations in respect of settlement agreements are:

  • The employee's contract of employment should not make any reference to the employer reserving the right to make a payment 'in lieu of notice'. If contracts have such a reference, any compensatory payment 'in lieu of notice' that forms part of the settlement amount will be to be liable to deductions for tax and N.I. because they are a 'contractual right' and an emolument arising out of employment;
  • As part of the agreement, the employee must warrant and undertake that he or she has not and will not commence legal action against the employer including action on the grounds of discrimination or unfair or wrongful dismissal;
  • Because the employee is required to waive his or her employment rights, the agreement must require the employee to have sought independent legal advice from a relevant independent advisor, typically a practicing solicitor, and require this advisor to confirm that such advice has been given. Apart from a practicing solicitor a 'relevant independent advisor' can be: a certified and authorised officer, official, employee, or member of an independent trade union or a certified and authorised advice centre worker. The adviser must not be employed by, acting for, or connected with the employer;
  • It is customary for the employer to pay a contribution towards the employee's legal costs incurred in seeking independent legal advice (typically between £350.00 and £500.00);
  • It is customary for payments under a compromise agreement to be made within 7 - 14 days of the agreement being reached.  For substantial payments it is not, however, unusual for the payment to be made in instalments;
  • It is usual for the employer to agree to provide a reference in an 'agreed form' as part of the agreement;
  • The settlement agreement should include a tax indemnity in favour of the employer in respect of any tax liability that may attach to the termination payment.  This is often challenged by the employee; however it is essential that this provision is kept in the agreement as no employer can legitimately guarantee that a tax liability will not be deemed to arise by HMRC on any payment. 

Because there are differences between the way things are defined under employment law and tax law, great care needs to be taken in drawing up and executing a settlement agreement. It is therefore highly advisable to seek professional advice before entering into such an agreement.