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Tax Indemnity Clause in Settlement Agreement

Employment and Discrimination Law

Tax Indemnity Clause in Settlement Agreement

Postby Scienke » Fri May 12, 2017 9:46 pm

Most settlement agreements have a tax indemnity clause where the employee is asked to indemnify the employer should HMRC decide that the compensation payment should be taxed.

As i understand it under section 403 Income Tax (Earnings and Pensions) Act 2003 the first 30k is usually paid tax free as an incentive to come to a quick arrangement and anymore should be taxed at the normal income tax rate.

I know that HMRC are pretty much God. But under what circumstances could they go against the above legislation and suddenly decide that the agreement in place between ex employer and ex employee is wrong and demand that tax be paid on the 30k?

And at what rate would the tax be paid? Could they just impose whatever rate they like or would it be the regular income tax rate?
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Re: Tax Indemnity Clause in Settlement Agreement

Postby atticus » Fri May 12, 2017 10:06 pm

Yes. There are sections in a tax statute that govern this.

Otherwise Income Tax rates apply - gross up the payment made as if it was a payment after tax to work out the tax that should have been paid.
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Re: Tax Indemnity Clause in Settlement Agreement

Postby Scienke » Fri May 12, 2017 10:19 pm

What needs to happen for HMRC to decide that what was believed to be tax free is now taxable? Do HMRC just change their mind if they decide they need some cash or is there some sort of criteria that needs to be filled before they can start taxing people retrospectively? ?

I'm all googled out. I can't find a search term that brings to anything specific.
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Re: Tax Indemnity Clause in Settlement Agreement

Postby dls » Sat May 13, 2017 5:17 am

It is earned income and in essence taxable.
The scheme gives exemption to certain payments if they meet certain conditions. It is for the employee to make sure that whatever conditions are required are met. Check the conditions.
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Re: Tax Indemnity Clause in Settlement Agreement

Postby atticus » Sat May 13, 2017 7:27 am

Income Tax Earnings And Pensions Act 2003, sections 401 onwards.
Read this for a brief guide (from BDO accountants).

Edit- I remind you that you quoted the statutory section in your first post!
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Re: Tax Indemnity Clause in Settlement Agreement

Postby Scienke » Sat May 13, 2017 10:36 am

dls wrote:It is earned income and in essence taxable.


If it is a compensation payment and the employer in return doesn't have to worry about being taken to court then is it still classed as earned income? Can compensation be earned in the same way as income?

dls wrote: The scheme gives exemption to certain payments if they meet certain conditions. It is for the employee to make sure that whatever conditions are required are met. Check the conditions.


Where are these conditions to be found? In the settlement agreement itself, or in the employment contract, or in the ITEPA 2003 legislation, or all of the above?

Employment solicitors aren't tax lawyers so I doubt they can really advise in depth on this. Their advice on this is often along the lines of "The first 30k is tax free but if HMRC change their mind about that and decide they want to tax it then it's down to you to pay the tax rather than the employer".

The employee is then left wondering under what circumstances could HMRC change their mind and why are you being told it's tax free if it may not be.

atticus wrote:Income Tax Earnings And Pensions Act 2003, sections 401 onwards.
Read this for a brief guide (from BDO accountants).

Edit- I remind you that you quoted the statutory section in your first post!


Thanks for the link although it doesn't actually give any detail on how a compensation payment that an employee was told was not subject to tax can suddenly become subject to tax. It just says
Generally, statutory and non-statutory redundancy payments, as long as they are categorised correctly, fall on the right side of the exemption. Ex-gratia and other compensation payments may not.


404 of ITEPA 2003 Legislation states

(4)If payments and other benefits are received in different tax years, the £30,000 is set against the amount of payments and other benefits received in earlier years before those received in later years.

(5)If more than one payment or other benefit is received in a tax year in which the threshold is exceeded—

(a)the £30,000 (or the balance of it) is set against the amounts of cash benefits as they are received, and

(b)any balance at the end of the year is set against the aggregate amount of non-cash benefits received in the year.


Is this saying that the decision to tax you on the previously agreed tax free sum can be based on the amount of tax you've already paid that year or in previous years?
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Re: Tax Indemnity Clause in Settlement Agreement

Postby atticus » Sat May 13, 2017 11:13 am

There is no taxation without legislation. The answers to your questions are to be found in the legislation. Now I am not an expert on tax law; nor So far as I am aware are any of the regulars here.

The main risk in termination payments relates to PILON clauses - payments in lieu of notice. If a contract says the employer may terminate immediately on making a PILON, that is a contractual payment, and does not qualify for the exemption.

The simple point is that if a payment does not come within the exemption, it is taxable.

If your question is specific and not hypothetical, and there is enough at stake, you should get appropriate professional advice.
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Re: Tax Indemnity Clause in Settlement Agreement

Postby atticus » Sat May 13, 2017 11:31 am

NB when advising on a settlement agreement I check whether the employment contract contains a PILON clause. If it does not, I explain the tax indemnity. I say that the payment appears to come within the exemption, but that HMRC may ask to see the settlement agreement and other documents, and that if they determine that the criteria for the exemption are not met, will assess the employer for tax, and the employer will call on the indemnity.

I do not say that HMRC might change its mind.
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Re: Tax Indemnity Clause in Settlement Agreement

Postby Scienke » Sat May 13, 2017 12:06 pm

Thank you Atticus. That does help to explain things a little better.

And of course, I or anyone who isn't clear about such things must seek out proper specialist legal advice based on the specifics of their own personal circumstances.
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Re: Tax Indemnity Clause in Settlement Agreement

Postby Scienke » Sun May 14, 2017 5:59 pm

Out of interest. And this is just a hypothetical scenario.

X signs a settlement agreement with Z that includes a tax indemnity clause making the employee liable if the employer gets it's tax sums wrong re the agreement.

But under this indemnity clause in the agreement the employee is also liable to pay for fines or penalties the employer may incur as a result of this tax oversight.

The settlement agreement says that if the employee breaches any part of the agreement the employee will pay back all the money.

If the settlement amount was for 5k but it turned out that this 5k was subject to tax and because the employee agreed to the indemnity clause with the tax, fines and penalties incurred the amount payable was now 7k. 2k more than the actual amount of the settlement agreement itself.

If the employee just gave back the original 5k and tore up the whole agreement would he no longer be bound by the tax indemnity clause and therefore no longer liable to pay the the 7k tax bill? Or is he now locked into whatever mess the employer has got themselves into regarding the tax because he signed the indemnity clause?
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