HM Revenue & Customs (“HMRC”) has produced a consultation paper “Simplifying the PAYE Settlement Agreement (PSA) process” on the taxation of settlement agreements. The consultation is open until the 18th October 2016 and the proposed legislation is due to be implemented in April 2018.

One of the reasons HMRC produced the consultation paper is because it thought employers were trying to manipulate such payments to try and ensure the payments were paid tax-free, so they were paid in the most favourable way for both parties, but not HMRC.

The proposals put forward by HMRC include:

Taxation of all payments in lieu of notice

Currently, all contractual payments in lieu of notice are taxable. If there is not any contractual entitlement to pay salary in lieu of notice, it might be possible to pay it tax free as the employer is arguably acting in breach of the employment contract.

The proposed legislation is that all payments in lieu of notice will be taxable regardless of the contractual position, meaning the only payment under a settlement agreement which will be tax free will be the compensation element of up to £30,000.

Payments of Employer National Insurance Contributions  

Currently, the first £30,000 of compensation (not including payment in lieu of notice) can be paid tax free. If the settlement figure is over £30,000 employers are required to deduct the tax prior to making payment to the employee.

The proposed legislation will require employers to deduct Employer National Insurance contributions from any payment over £30,000 prior to making the payment to the employee.

Injury to Feelings  

Currently, there is confusion as to whether tax is payable or not on awards for injury to feeling claims, which usually arise in discrimination claims.

The legislation proposes that all compensation payments for claims made for injury to feelings will become taxable. Therefore, while this will mean less scope to pay more compensation tax-free, the legislation will, at least, provide clarity as to whether tax is payable on any injury to feelings award.

Please contact your dedicated EmployLaw solicitor if you require any assistance with drafting a settlement agreement.

Please be aware that we cannot provide specific tax advice on settlement agreements and you will need to speak to your accountant for more detailed information.