Settlement Agreements

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Settlement Agreements

What is a Settlement Agreement?

A Settlement Agreement[1] (previously known as a compromise agreement) as the title implies and is a way for an employer and employee to come to an arrangement whereby the employment will end on date agreed by the parties, with usually the employer paying the employee agreed compensation or a termination payment in full and final settlement and the employee leaves the business.

What is in a compromise agreement?
A compromise agreement (which is now called a Settlement agreement) is a legally binding agreement either during or following the termination of your employment, and which brings your employment to an end. It was recognised by statute and was the only way you can validly "contract out" of your employment law rights.
What is a COT3 agreement?

A COT3 agreement is another form of a settlement agreement that is reached with the help of an ACAS conciliator. This is where ACAS is or has been involved with a potential employment tribunal[2] claim or part of the early conciliation;[3] the matter can be concluded without the need for independent legal advice. Of course, you are still free to seek legal advice on such a document.

Who are the parties to a Settlement Agreement?
An employer and an employee will be the named parties to an agreement here. Always remember Employment law is quiet complex and it is always best to seek legal advice to make sure you know your rights and options available to you before making any decision to accept the agreement.
Is a settlement agreement tax free?

The short answer is, provided the settlement agreement is drafted well. If you use up your holiday entitlement, work your notice period, and your payment is under £30,000, then the answer is yes, the settlement agreement is tax free.

The amount of tax you pay will of course make a big difference in the amount you eventually receive, and the last thing you want after agreeing on a settlement you are happy with is to find out later on that you’re not going to get what you thought.

The rules on taxation of payments made to you by your employer, including in settlement agreements, are covered by the usual tax legislation, namely the Income Tax (Earnings and Pensions) Act.[4]

The rules are slightly different according to whether or not the settlement agreement is concerned with your leaving that employment.

Is there tax on a settlement agreement when you are leaving or have left the job?

When you are leaving a job, whatever payments the company make to you are called “Termination Payments” by HMRC,[5] regardless of whether they are redundancy payments, compensation for unfair dismissal, pay in lieu of notice (commonly abbreviated to PILON), payment for holiday accrued but not taken, or simply payment of the wages owed. As long as the payment is made as a direct result of your employment being terminated, for whatever reason, then the tax laws covering Termination Payments will apply.

The basic rules for a termination payment you receive as part of your settlement agreement is that the first £30,000 of an ‘ex gratia’ termination payment is tax-free.

However, sometimes in practice, it is not always quite so simple to apply and will always depend on the particular circumstances, which is why you need to take advice. First of all the question will be, what is meant by “ex gratia”[6] – this just means, ‘a gift’ to end your employment. In tax law and employment, as your employer was not obliged to make any payment under the terms of your employment contract with the exception of redundancy payments it is classed as a gift.

Often your total payment will be made up of several different payments. Some of these may be ex-gratia, some will not be.

Will payment in Lieu of Notice be tax free or taxed?

The answer to this question will all depend on whether or not your original contract of employment entitled you to a payment in lieu of notice.[7] If your contract says that you are entitled to it, then payment in lieu of notice is a payment your employer is obliged to pay you. As such, it is not ex gratia and will be taxable.

If your employment contract does not provide for payment in lieu of notice, then both you and your employer will be free to negotiate whether or not you will have pay in lieu of notice, and therefore your employer is not obliged to pay you. As such, the payment is ex gratia for tax purposes, and will not be taxed (up to the £30,000 limit).

Will payment owed for wages be taxed?
The answer is yes, wages due to you are part of your normal earnings and not really anything to do with your leaving; they will be taxed as normal.
Will outstanding holidays owed be taxed?
The answer is yes, any holidays paid as part of a settlement agreement would be taxed in the normal way.
Will payments for entering Into Restrictive Covenants taxable?

A restrictive covenant is an agreement between and employer and employee and that the employee will not do certain things within a certain period after leaving employment or within a certain distance from your old place of work. Such agreements are usually concerned with your not taking business away from your employer

Payments for agreeing restrictive covenants are considered to be earnings and are taxable.


Why a Settlement Agreement?

This is an alternative and usually an amicable way of resolving an issue, dispute or situation that has arisen between an employer and an employee. There may be many reasons and situations why parties may choose to adopt this method. It may be a redundancy[8] situation and the employer wants to avoid going through the process required, or may be that the employee has raised a grievance and if the relationship between the parties has gone downhill this may be a preferred way of resolving the matter without having to worry about a constructive dismissal action in an employment tribunal. Another type of situation may be the employer wishes to avoid going down the procedures he would normally be expected in law to follow and he wishes to by-pass this to deal with a situation quickly. There can be many reasons why the parties may choose to resolve the issues by this method.

Do I need to take legal advice on a settlement agreement?

The answer to this question is a definite yes; you are in fact signing away your Employment Rights, which means, once you have signed the settlement agreement you can’t pursue your employer for any employment related claims. This is why it’s so important that you get the right legal advice.

Sometime individuals can be surprised by the offered a settlement agreement especially if they are leaving their employer on amicable terms. However, employers will often use settlement agreements as a matter of course just to be on the safe side if there could be a possibility of a claim down the line.

Also, a settlement agreement is not legally binding unless the employee has had advice from a relevant independent adviser as set out in the legislation.[1]

It is important if you feel that you have a potential claim against your employer, let your solicitor know all the details because they will then be able to advise on whether the money being offered in the agreement is appropriate.

How much is legal advice on a settlement agreement?

The cost of the legal will vary depending on the complexity of the particular facts of the situation. The employer will always inform and tell their employee that they have to get legal advice because it isn’t valid if the employee doesn’t get legal advice.

The normal practice is the employer usually agrees to pay a contribution towards the legal costs of the individual getting that independent legal advice. This is because it is certainly as much in the employer’s interests to ensure the agreement is valid as it is in the employee’s interests. 

The amount of the contribution paid by the employer will range depending on the complexity of the agreement and the part of the country you are based, but typically it is between £250 and £500 and in most cases it will cover all the costs so it is important that you discuss this with your solicitor.

Is the settlement agreement figure being offered fair?

There is no right or wrong answer here but as you are waiving all your right away regarding bringing any claims, the amount being offered should reflect the value of any potential tribunal claims you may have.[1]

You will need to discuss this with your solicitor and the starting point will be looking at:

Are there any potential claims you could bring against your employer?

If yes, what is the likelihood of winning the claim at a tribunal?

If you are successful, how much would you be likely to recover?

How long would it take and what would be the cost of pursuing the claim?

The answers to these questions and maybe other others raised by your advisor will affect the amount that you think you should expect in the settlement agreement and may help you decide whether to negotiate or not.

Can I negotiate on the settlement agreement I have been offered?

It could be the case that the employee is very happy with what they have been offered in a settlement agreement and just want to sign and move on.

There are, however, situations where the employees feel that the employer is not being fair and feel they deserve and are entitled to more.

So the answer is yes of cause you negotiate of the settlement agreement and whether you are successful will depend on a range of circumstances and of cause how far you want to challenge your employer.

The negotiation strategy may involve threatening to make an employment tribunal claim and most often will involve raising a formal grievance.[9]

There are some employers that will not negotiate and some have been known to threaten to withdraw the current offer, so it is important to keep in mind:

The grievance procedure will involve at least two meetings including the appeal process

The employment tribunal procedure is likely to take at least 6 months

The employer may continue with any performance or disciplinary process

Your solicitor and/or trade union representative will be able to advise you on the prospects of success and will also be able to assist you with any internal process.

Your solicitor or trade union rep will be able to advise you on the best strategy for negotiation.

How does the idea of a Settlement Agreement come about?

Usually either party may plant the seed and have a without- prejudice discussion[10] with each other.

The nuts and bolts of it.

Once the idea has been planted and taken on board by the employer and employee there will be some negotiations conducted to agree on terms of the settlement. The employer is then required to present the employee with a written document. The employee will need to take independent legal advice on it.

This is important for 2 reasons,

  1. there is a requirement in law for the employee to seek independent legal advice and
  2. the lawyer advising needs to give a certificate that he has given independent advice and has the appropriate indemnity cover. Once happy with the terms, the employee will sign the document, the lawyer then signs off the certificate after the employee has signed and it is then sent to the employer or their representative if acting through one for the employer to complete the documentation process by signing. Once the employer has signed the document becomes a binding agreement in law and the process is completed by the employer forwarding a signed copy to the employee for their records and of course the employee being paid the compensation monies within the time agreed in the Settlement Agreement. It is very usual with a few exceptions for the employer to insist that not only the terms of the settlement as kept confidential but the very existence of it. So the employee must not disclose to the outside world of the agreement and its terms. There are many important terms in the agreement on which legal advice must be sought, not least tax implication in respect the various payments to be made to the employee under the agreement. They are formal legal documents and fully binding in law when signed by both parties which deal with legal rights and so it is very important that legal advice is taken at a very early stage.
Can I get a Reference with the settlement agreement?

There is no legal obligation on an employer to provide a reference[11] for an employee or ex-employee. In reality employers can refuse to provide a reference if they want to. It is, however, common practice to include as part of the settlement agreement an agreed reference.

The reference is usually annexed to the agreement and will often be very basic and provides minimal information such as start date, finish date and job title, so if you want a reference let your solicitor know and he can make sure that it is included.

[1] Participation E. Employment Rights Act 1996 agreement [Internet]. [cited 2017 Mar 30]. Available from:
[2] Employment Tribunal - GOV.UK [Internet]. [cited 2017 Mar 30]. Available from:
[3] Home - Early Conciliation Notification Form [Internet]. [cited 2017 Mar 30]. Available from:
[4] Participation E. Income Tax (Earnings and Pensions) Act 2003 [Internet]. [cited 2017 Mar 21]. Available from:
[5] Income Tax and National Insurance contributions: treatment of termination payments - GOV.UK [Internet]. [cited 2017 Mar 30]. Available from:
[6] Meaning of ex-gratia-payment [Internet]. [cited 2017 Mar 30]. Available from: [7] Understanding PILON: Payment in lieu of notice | Acas Workplace Snippet September 2013. 2013 Sep 30 [cited 2017 Mar 30]; Available from:
[8] Redundancy | Advice and guidance. 2008 Feb 14 [cited 2017 Mar 30]; Available from:
[9] Raising a grievance at work | Acas advice and guidance. 2008 Feb 14 [cited 2017 Mar 30]; Available from:
[10] Having an off the record conversation [Internet]. Castle Associates Ltd. 2016 [cited 2017 Mar 30]. Available from:
[11] References: workers’ rights - GOV.UK [Internet]. [cited 2017 Mar 30]. Available from:


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