Settlement Agreements: what are they?

by Liz Talbot

A Settlement Agreement is one reached between an employer and an employee where the employee agrees that his employment will terminate on a given date and the employer contracts to pay the employee a lump sum, usually within fourteen or twenty eight days of the date of termination.

Why are these agreements attractive?

From the employee’s point of view, he has the security of knowing that, when he leaves his employment, he will receive any contractual payments under the payroll and in addition receive a lump sum which has been negotiated.  The employee also agrees not to make a claim to any tribunal or Court in respect of his or her employment.

From the employer’s point of view, they will have to pay the lump sum but the employee is contractually bound not to make a claim to an Employment Tribunal or a Court of Law.

Under the Tax Statutes, any payment up to £30,000 made under a settlement agreements is exempt from payment of Tax.  When the compromise agreement is signed before the employment termination date, the Inland Revenue (now known as HMRC – Her Majestys Revenue & Customs) can argue that the agreement is no more than a variation of the employee’s contract and so the usual £30,000 exemption from Tax for termination payments will not apply.  In practical terms, this is unlikely if the agreement is signed only a few days before the termination.

Care has to be taken to avoid any reference to termination by mutual consent. The reason for this is that termination by mutual consent amounts to a discharge of a contract, not a breach of contract. This is important because breach of contract is required by HMRC before any termination payment is treated as damages. Therefore, HMRC will probably consider a mutual consent termination to be a variation of contract and the £30,000 exemption will not apply.  In practice, it is therefore better to agree an acceptable reason for dismissal (eg: redundancy).

It should also be borne in mind that any statutory redundancy payment will be tax free but will be allocated to part of the £30,000 (and so use up part of that allowance ). If there is a payment in lieu of notice clause in the contract, then the employer should probably deduct tax and national insurance contributions (or at least be aware of the risks of not doing so).

If you have an queries relating to Settlement Agreements please contact me at lizt@bonellaw.co.uk or call us on 01789 299115 and I’ll be glad to assist.

Find out more