The answer to this is very likely to be...NO

Settlement agreements can provide a useful way of bringing what might be a difficult employment relationship to an end. They offer peace of mind for the employer, considerably lowering the risk of any employment tribunal or court claims. For the employee, they can offer the incentive of a lump sum payment. In the past, "compensation" or "ex gratia" payments above and beyond any contractual notice pay might have been offered tax free. That is, as a payment in connection with termination coming within the £30,000 tax exemption threshold under sections 401-416 Income Tax (Earnings and Pensions) Act 2003.  

New tax rules brought in on 6 April 2018 (but still frequently overlooked or misunderstood) mean that this is frequently not now possible.

The new tax rules on termination payments (from 6 April 2018)

Notice pay or its equivalent is now always taxed as earnings; whether as contractual pay in lieu of notice (PILON) or as a non-contractual payment. It is irrelevant how the payment is labelled by the employer. Any rounding up of a payment based on notice pay (as might have been proposed under the old rules) will also have no impact on the application of the new rules.  

If the contract includes a right to a PILON

In this case, notice pay under the contract will be subject to deductions (as was previously the case) and the new rules will not apply.

If there is no contractual PILON

The amount which would have been paid for any unworked notice must be calculated (based on actual pay during the last pay period).  This is called Post-Employment Notice Pay (PENP). Any PENP within a severance payment will be subject to tax and National Insurance contributions (NICs). It is important to note that the notice period in question is the notice the employee would be entitled to from the employer immediately before termination.

For example

An employee would be entitled to one month's notice from the employer. She earns £2,000 gross per month. A settlement agreement is proposed including a severance payment of £10,000. No notice will be worked. There is no right to pay in lieu of notice in her contract. £2,000 of the payment (pay for the one month notional notice period) will be subject to tax and NICs. The remaining £8,000 will be exempt from tax as a termination payment coming under the £30,000 threshold.

Where some or all notice is worked

If the employee works the full notice period, there will be no "Post-employment Notice Period" and no PENP. In that case, any termination payment is likely to be payable without deductions. Employers should ensure that they have a paper trail showing that notice was given and worked.

However, there are risks for both the employer and the employee in giving notice unilaterally. If the employer gives notice, this is effectively a dismissal and could give rise to an unfair dismissal claim if the settlement agreement is not ultimately agreed. If the employee gives notice, this is a resignation. The risk for the employee is that the employer might accept this without going on to agree any settlement terms. To protect both parties, it is therefore advisable for the settlement agreement itself to record that notice has been given on the date of the agreement. You should be aware that HMRC may seek documentary evidence to support the employer's tax treatment of any severance payment.

Where some but not all the notice period is worked, this will reduce the impact of the new rules. Deductions should be made only on the equivalent of pay for the unworked notice period.

Employees on reduced pay

PENP is based on the amount the employee earned as basic pay in the last pay period before termination. Broadly, where pay is reduced, this is the figure which is used for the calculation. If an employee were to be on half pay, for example due to sickness absence or contractual maternity pay, in the last month before termination, the calculation would be based on half pay for the notice period and so deductions would be lower. If pay has reduced to nil, the PENP calculation will also be nil.

There is some uncertainty as to whether Statutory Sick Pay or Statutory Maternity Pay should be included in the PENP calculation. HMRC guidance indicates that these payments should be included as part of basic pay, but commentators have suggested that this may not reflect the meaning of the tax legislation. As a very new area of the law, such uncertainties have yet to be tested in the tax tribunal or courts.

ACAS settlements and tribunal awards

The new tax rules extend beyond settlement agreement payments to any "relevant termination award". This will include payments made during and after the early conciliation process through an Acas COT3 agreement and awards ordered by a tribunal where these are in connection with the termination of employment.

Even where the employee was dismissed for gross misconduct and so was arguably not entitled to notice pay on termination, the new rules will still apply to any settlement payment or award relating to the termination.

Redundancy Pay

The main exception to the new rules is that the amount due to a redundant employee as statutory redundancy pay (SRP) can be paid tax free.

Contractual enhancements to SRP are not exempt however. This means that tax and NICs will have to be deducted from any amount over SRP where it is PENP. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.