Compromise Agreements - Tax Position Clarified

A compromise agreement is an agreement made between an employer and an employee who is having their contract of employment terminated. It sets out the terms under which the termination will take place and contains a provision that the employee will receive a lump sum payment. It is normal for such an agreement to contain a clause to the effect that as a result of the agreement, the employee will not take any legal action as regards the termination of their employment. The agreement therefore acts as a protection for the employer. Normally in such circumstances payments up to £30,000 are exempt from a charge to income tax.

To be accepted as a full and final settlement, the agreement must be in writing and relate to the particular proceedings. It must be entered into by the employee under independent advice and the adviser must be identified in the agreement and must have professional indemnity insurance covering the advice given. The agreement must also state that the above conditions are satisfied.

Recently, the Inland Revenue attempted to tax the lump sum payments made in such cases. Their argument was that where the compromise agreement stipulates that in the event of a future legal action between the parties, the payment is refundable (a common clause), the whole amount of the payment would be taxable in the hands of the employee.

Following protests, the Revenue has backed down, agreeing that:

• compromise agreements contain an implied undertaking not to issue proceedings against the employer;
• it makes no difference if that undertaking is set out expressly as part of a repayment clause provided the sum of money payable under the compromise agreement is a real attempt to compromise the substantive claims;
• no tax is chargeable on any aspect of the monies paid under a compromise agreement, even where that money is repayable if the employee breaches an undertaking not to commence litigation.

However, if the amount paid under the agreement is excessive with regard to the right to take action forgone, the Revenue reserves the right to investigate.

 

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