The general rule is that the first £30,000 that an employer will pay out in compensation as part of a compromise agreement is tax free. The tax arrangements for a particular agreement vary according to a number of different considerations.

• All payments made for salary and benefits up to the date of the contract of employment are liable for tax and national insurance deductions in the normal way.
• Payments made in lieu of holiday are taxable and this is still the case if the holiday is the time owing to an employer once their employment has ceased.
• The tax situation for pay in lieu of notice is dependent on whether these payments are allowed according to that employee’s contract of employment, though the information may be in an employee handbook instead. If allowed they are taxable the same as other contractual payments, whereas if they are not, they can be paid gross and will go towards the £30,000 exemption.
• If it is the usual practice of the employer to make payments in lieu of notice, even if not part of the contract, it may be that the HMRC determines that tax should be deducted.
• Non-contractual or compensatory payments for the loss of office or employment are not subjected to tax on the first £30,000.

Payments for restrictive covenants and confidentiality obligations deal with former employees competing with their former employers or approaching old customers or former work colleagues. The employer can rely upon the restrictive covenants if they have not been affected by the ending of the employment. However, if this is not the case or if the covenants cannot be relied upon for any other reason, the employer can look for new restrictions, though they will have to pay for them by way of a small amount of “consideration”. This sum is taxable and is also liable for national insurance contributions.

Other payments include those for injury to feelings. These payments will not be taxable although payments will be subject to tax if the person’s feelings have been injured as a direct result of the termination of their employment. Equally, payments are also tax free where they are made on account of a disability or injury.

Statutory and contractual redundancy payments are within the £30,000 exemption, while payments directly into a pension scheme are not subjected to tax. Also not taxable are payments made to go towards outplacement training. Legal costs also do not count towards the £30,000 exemption.

Before April 2011 any compensation that went over the £30,000 limit was taken off at basic rate on the additional amount. The employer now has to take off tax at the OT tax code rate with the rate dependent on the size of the excess.