COT3 Agreement Tax-Free Rules: The £30,000 Exemption and PENP

The tax treatment of a COT3 agreement follows one simple rule and a lot of exceptions: the first £30,000 of a genuine termination payment is free of income tax and employee National Insurance, and everything else in the settlement is taxed according to what it actually represents. HMRC ignores the labels the parties choose. Unpaid wages stay wages. Notice pay stays notice pay. Only the portion that genuinely compensates you for losing your job qualifies for the £30,000 exemption, and that threshold still applies for the 2025–26 and 2026–27 tax years.

The £30,000 Exemption and What It Covers

Section 401 of the Income Tax (Earnings and Pensions) Act 2003 brings termination payments into the tax net, and Section 403 provides the relief: the first £30,000 of qualifying termination payments is exempt from income tax.¹ Qualifying payments, sometimes called ex-gratia payments, compensate you for losing the job rather than reward work you already did. Statutory redundancy pay, enhanced redundancy pay, and non-contractual compensation for termination all fall inside this category. If the money was already owed under your contract of employment, it counts as earnings, and the £30,000 shelter does not apply.²

The £30,000 is not a per-payment limit. It is a lifetime cap tied to the same termination event. Section 403(4) requires you to add together every payment and benefit that falls under the termination provisions and apply the threshold to the total.¹ If you receive a £10,000 statutory redundancy payment and later settle a COT3 for £25,000 in compensation, the combined total is £35,000, and only the first £30,000 escapes income tax.

Anything above the threshold is subject to income tax at your marginal rate. Employee National Insurance contributions, however, remain exempt on the whole termination payment, including the excess above £30,000.³ The employer’s NIC position on the excess is different, and covered further down.

Parts of a COT3 That Are Taxed as Earnings

Some of the money in a COT3 will represent things you would have been paid if you had stayed. HMRC treats those sums as ordinary earnings. Full income tax and employee National Insurance are deducted at source, and the amounts sit entirely outside the £30,000 threshold. The common items are:

Unpaid salary or wages up to your last working day.
Accrued holiday pay for leave earned but not taken.
Bonuses or commission already earned before termination.
Benefits in kind, such as continued use of a company car, valued as earnings.

Careful drafting matters. Each element should be broken out separately so payroll applies the right treatment. If a COT3 lumps everything into a single “compensation” figure, HMRC may investigate and reclassify portions as earnings, which can produce underpayment penalties.

Post-Employment Notice Pay

Since April 2018, employers have had to calculate Post-Employment Notice Pay (PENP) on every termination where the employee does not work their full notice.⁴ The logic is that money for a notice period you did not work is really wages, regardless of what the COT3 calls it. The employer strips out the notice equivalent and taxes it as earnings, with both income tax and NICs deducted.

Section 402D of ITEPA 2003 sets out the calculation:⁵

PENP = (BP × D ÷ P) − T

BP is your basic pay in the last pay period ending before the trigger date. It excludes bonuses, commission, and benefits.
D is the number of calendar days in your unworked notice period.
P is the number of calendar days in the last pay period.
T is any contractual payment in lieu of notice already taxed as earnings.

A negative result is treated as zero. For monthly-paid employees whose notice period is a whole number of months, a simplified version applies: P becomes 1 and D is counted in months. Where the unworked notice period is not a whole number of months but the employee is paid in equal monthly instalments, P is replaced by 30.42 (365 ÷ 12).⁶

PENP reduces the pot available for the £30,000 exemption. A settlement that looks generous can shrink significantly once notice pay is stripped out and taxed as earnings.

Injury or Disability Payments

Section 406 of ITEPA 2003 creates a separate exemption that sits outside the £30,000 cap entirely. A payment made on account of injury to, or disability of, the employee is not taxable under Section 401, whatever the amount.⁷ For someone genuinely harmed during their employment, this can be worth a great deal.

The word “injury” here means a medically diagnosable condition. HMRC’s guidance states that the term includes psychiatric injury but does not include injured feelings.⁸ Injury to feelings, which often arises in discrimination claims, is not a medical condition and does not qualify. Any award for injury to feelings falls back into the general pot and uses up part of the £30,000 threshold.

Documentation from a medical professional confirming a diagnosed condition caused or worsened by the employment is what makes this exemption stand up. Vague references to stress or upset, without a clinical diagnosis, will not satisfy HMRC.

Restrictive Covenant Payments

Some COT3 agreements include a payment in exchange for the employee agreeing not to compete, not to solicit clients, or not to work for a rival. Section 225 of ITEPA 2003 treats any payment for a restrictive undertaking as earnings from the employment, taxable in full with income tax and National Insurance.⁹ The £30,000 exemption does not apply.

Allocating part of a settlement to a restrictive covenant can therefore backfire. If £5,000 of a £35,000 COT3 is labelled as consideration for a non-compete clause, that £5,000 is taxable as earnings on top of whatever else is owed. If the covenant is being genuinely imposed and has real commercial value, the allocation may be unavoidable, but it should be negotiated with the tax consequences in mind.

Legal Fee Contributions

Employers often agree to pay a contribution towards the employee’s legal fees. HMRC’s Employment Income Manual sets out three conditions that must all be met for the payment to fall outside Section 401 and remain untaxed:

The employer must pay the solicitor’s firm directly rather than route the money through the employee.
The legal costs must relate solely to the termination of employment.
The COT3 must include a distinct clause providing for the payment of legal fees.

Where all three are met, the legal fee contribution is not charged under Section 401 and does not eat into the £30,000 threshold.¹⁰ The most common mistake is the employer paying the employee and expecting them to pass the money on to their solicitor, which fails the first condition.

Employer National Insurance Above £30,000

Since April 2020, employers have owed Class 1A National Insurance on the portion of a qualifying termination payment that exceeds £30,000.¹¹ For 2025–26 the Class 1A rate is 15%.¹²

The cost falls on the employer, not on you, but it shapes negotiations. Employers paying a large termination sum now face a 15% NIC bill on everything above £30,000, and that often explains resistance to certain headline figures during settlement talks.

How the Tax Is Deducted and Reported

The employer handles the tax through PAYE. Payroll separates the taxable elements (ordinary earnings, PENP, restrictive covenant payments) from the qualifying termination payment, applies income tax and NICs to each portion, and pays the net amount to you. You should receive a payslip or a P45 showing the gross payment and the deductions.

If you are a higher-rate or additional-rate taxpayer, the PAYE deduction may not fully capture your liability, and you will need to report the payment on your Self-Assessment return for the relevant tax year. HMRC can open enquiries into settlement payments, particularly where the split between taxable and exempt elements looks aggressive or is thinly documented. Keep the COT3, any medical evidence, and the payroll records.

The tax year in which you actually receive the payment determines when it is taxed, not the year the dispute arose or the year the COT3 was signed. If a settlement straddles April, the timing of the payment itself decides which year’s allowances and rates apply.¹

1
Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003 – Section 403
2
GOV.UK. Employment Income Manual – EIM13000
3
GOV.UK. Tax on Termination Payments – What You Pay Tax and National Insurance On
4
GOV.UK. Changes to the Treatment of Termination Payments and Post-Employment Notice Pay for Income Tax
5
Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003 – Section 402D
6
GOV.UK. Employment Income Manual – EIM13886 – PENP Formula: How to Calculate P
7
Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003 – Section 406
8
GOV.UK. Employment Income Manual – EIM13610 – Termination Payments and Benefits: Exceptions: Payments on Account of Injury or Disability
9
Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003 – Section 225
10
GOV.UK. Employment Income Manual – EIM13740
11
GOV.UK. 2026: Class 1A National Insurance Contributions on Benefits in Kind, Termination Payments and Sporting Testimonial Payments
12
GOV.UK. National Insurance Rates and Categories: Contribution Rates