Under a compromise agreement, tax-free treatment applies to the first £30,000 of a genuine termination payment: that slice is free from income tax and employee National Insurance contributions. Anything above £30,000, and anything that isn’t really compensation for losing your job, is taxed as ordinary earnings. The threshold has stood at £30,000 since 1988 and applies automatically to qualifying payments with no election or claim needed.
One point of terminology before the rules. “Compromise agreement” was renamed “settlement agreement” in 2013 by section 23 of the Enterprise and Regulatory Reform Act. The tax treatment is identical, and older agreements signed under the previous name remain valid.
What the £30,000 Threshold Actually Covers
Section 403 of the Income Tax (Earnings and Pensions) Act 2003 says a termination payment only counts as taxable employment income to the extent it exceeds £30,000.1Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003, Section 403 To qualify, the payment must fall within section 401, meaning it was received in connection with the termination of employment rather than as a reward for work done.2Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003, Section 401 Statutory redundancy pay, enhanced redundancy pay, and ex gratia severance all qualify.3GOV.UK. Tax on Termination Payments – What You Pay Tax and National Insurance On
The trap most people don’t see: every payment connected to the same termination is aggregated before the threshold is applied. A £12,000 statutory redundancy payment plus a £25,000 severance sum is treated as £37,000, and tax applies to the £7,000 above £30,000.4HM Revenue & Customs. Employment Income Manual – EIM13500 Splitting the payment across months, or even across tax years, doesn’t help. It’s still one total.
Employee National Insurance is not charged on any part of a genuine termination award, even the taxable part above £30,000. The employer, however, owes Class 1A NICs on whatever amount sits above the threshold.5GOV.UK. National Insurance Manual – NIM13201 – Class 1A NICs on Termination Awards: Introduction That’s the employer’s problem on paper, but it becomes yours in practice: employers negotiating a package are often willing to reshape it (see pensions, below) to avoid that extra cost.
Post-Employment Notice Pay Never Gets the Threshold
Post-Employment Notice Pay (PENP) is the portion of a settlement that represents salary you would have earned had you worked your contractual notice. PENP is always taxed as earnings through PAYE, with full income tax and National Insurance, no matter how the agreement labels it.6GOV.UK. Changes to the Treatment of Termination Payments and Post-Employment Notice Pay for Income Tax It gets no benefit from the £30,000 exemption.
The formula: take your basic pay for one pay period, multiply it by the unworked pay periods in your notice, and subtract any payments already made for that notice. If you earn £3,000 a month, have a three-month notice period, and worked only one month, then £3,000 × 2 = £6,000 of PENP. Only what remains of the settlement after PENP is stripped out is available for the £30,000 exemption.
The practical consequence is worth thinking about before you sign anything. A long contractual notice period plus an immediate exit means a large slice of your settlement will be reclassified as PENP and taxed in full. Working most of your notice before leaving pushes more of the package into genuine termination territory.
Payments That Are Always Taxed
Several parts of a settlement are treated as ordinary earnings and go through PAYE regardless of the £30,000 threshold:
- Accrued but untaken holiday pay. It’s wages, not compensation for job loss.
- Contractual bonuses that had already crystallised before termination.
- Unpaid commission for work already done.
- Payments in exchange for restrictive covenants (agreeing not to compete, not to solicit clients). These are consideration for a future obligation, not compensation for loss of office, and are fully taxable.
Income tax and National Insurance come off these sums before your final payment lands. They appear on your payslip or P45 alongside regular salary, because that is what HMRC treats them as.
Payments That Can Sit Outside the Tax Net
Injury to Feelings from Discrimination
A payment for injury to feelings can be tax-free, but only if the discrimination happened before the termination rather than as part of it. HMRC’s position is that where the payment “can reasonably be attributed solely to discrimination occurring before the termination of employment, it should be accepted as not connected with the termination” and therefore falls outside section 401.7HM Revenue & Customs. Employment Income Manual – EIM12965 – Termination Payments and Benefits: Statutory Compensation for Discrimination and Compensation for Hurt Feelings If the discriminatory act was the dismissal itself, the compensation counts toward the £30,000 threshold instead.
Months of workplace harassment followed by a resignation gives a stronger argument for tax-free treatment than a discriminatory dismissal does. Misclassifying this is one of the quickest routes to a later tax bill.
Employer Pension Contributions
Employer contributions paid directly into a registered pension scheme are not taxable income to the employee and do not count toward the £30,000 threshold. Diverting part of a settlement into pension is one of the most effective ways to shelter amounts that would otherwise be taxed above £30,000, and it saves the employer its Class 1A NICs on the same money.
There is a ceiling. Employer contributions count toward the pension annual allowance, currently £60,000.8GOV.UK. Tax on Your Private Pension Contributions – Annual Allowance Unused allowance from the previous three tax years can be carried forward, so someone who hasn’t been making large contributions may have significant headroom. Exceeding the available allowance triggers an annual allowance charge that claws back the tax relief, so run the numbers before agreeing to a large diversion.
Legal Fees
The employer’s payment of your solicitor’s fees for advising on the agreement is tax-free under section 413A of ITEPA 2003, on two conditions: the costs were incurred exclusively in connection with the termination, and the employer pays the solicitor directly rather than reimbursing you.9Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003, Section 413A If the money passes through your hands, the exemption is lost. Most agreements include a clause requiring direct payment (often £350 to £500 plus VAT) to your solicitor, because section 203 of the Employment Rights Act 1996 requires independent legal advice for the agreement to be binding.10Legislation.gov.uk. Employment Rights Act 1996, Section 203
A Worked Example
You earn £40,000 a year with a three-month notice period, and your employer offers a £50,000 settlement. You work none of your notice.
First, calculate PENP. Monthly basic pay is about £3,333; three unworked months gives PENP of roughly £10,000. That £10,000 is taxed as earnings through PAYE with full NICs.
The remaining £40,000 is the termination payment. The first £30,000 is tax-free. The final £10,000 attracts income tax (but not employee NICs), and the employer owes Class 1A NICs on that same £10,000.3GOV.UK. Tax on Termination Payments – What You Pay Tax and National Insurance On
Now change one thing. Agree with the employer to pay £10,000 of that excess straight into your pension. The termination payment left in cash is £30,000, entirely inside the threshold. You pay no income tax on that portion, and the employer saves its Class 1A NICs. Both sides come out ahead, which is why pension diversion is worth raising whenever the total is heading above £30,000.
The Tax Indemnity Clause
Nearly every settlement agreement contains a tax indemnity, and it deserves more attention than most people give it. The clause is your contractual promise to reimburse the employer if HMRC later reclassifies a payment. HMRC pursues the employer first, because the employer operated PAYE; the indemnity lets the employer come after you for the shortfall.
This is not a theoretical risk. HMRC can open an enquiry years after payment. If a large sum was treated as tax-free injury to feelings compensation but the facts don’t cleanly separate it from the termination, the person who signed the indemnity ends up paying the underpaid tax, interest, and potentially penalties.
Before signing, ask your solicitor which payments the indemnity covers and whether the tax treatment the agreement assumes is defensible. A well-structured agreement makes the indemnity a formality. A poorly structured one turns it into a liability that follows you around.