Ex Gratia Payments
Ex gratia payments in settlement agreements (formerly called compromise agreements) are great things if you can get them, because they are a pretty unique tax break only really available to employees who are leaving work after a dispute or redundancy situation.
Top 3 TIPS
- Your first £30,000 should be tax free;
- You can ask for any redundancy consultation period pay to be paid ex gratia instead; and
- In theory your notice pay could be paid ex gratia, in practice it’s a lot trickier to arrange.
An ex gratia payment in a settlement agreement means that it is a payment which your employer is not legally obliged to make under your contract of employment. It is normally a gesture from your employer that they have treated you badly and that you deserve some financial compensation to make it up to you, and to avoid the need for you to sue them in an employment tribunal.
For such non contractual payments, there is tax break whereby up to £30,000 is not subject to income tax or NI deductions. Your employer just pays you the ex gratia payment, and then at the end of the tax year you declare it on an HMRC self assessment form, ticking the box marked ‘ex gratia’, and you are not taxed on it (read more on that below).
This would be as opposed to contractual payments, which your employer is obliged to pay you, like for example your salary, commissions or other benefits in respect of a period when you were actually working for your employer. It is of note that statutory redundancy payments are paid free of tax, so effectively are part of your ex gratia payment.
In the mid nineties, the government decided to introduce this tax break for ex gratia payments in settlement agreements in order to encourage people to settle their disputes early and out of court. If you go to an Employment Tribunal and win a claim there, you don’t get this tax break: so you might win £30,000 compensation after a successful employment tribunal, and the Judge would make an order that you would have to be taxed on this amount (so you might only receive say £20,000).
The reason that this tax break was brought in was that the government funds employment tribunals, including paying for the judges’ salaries and the courtrooms and so on, and this is expensive. Therefore it makes sense to offer tax breaks to encourage early settlement. To calculate roughly how much your ex gratia payment should be, try our Settlement Agreements Calculator. You might also want to read more on our How Much Money Should I Get article.
Ex gratia and notice periods
A grey area is ex gratia payments in relation to notice period. If your contract entitles you to say one month’s notice, then theoretically your employer could structure a settlement agreement so that you effectively receive this tax free. They can say ‘we are terminating your employment without notice’, thus technically breaching your contract, and then pay you an ex gratia payment instead. However, most employers shy away from this and decide to deduct income tax at source for the sum equivalent to any notice pay. On the other hand we know of some very big household name companies which are happy to pay notice pay as an ex gratia payment.
One way to calm employers’ nerves about this tax risk (as they see it) its often best to structure the settlement agreement payment so that the ex gratia element is not exactly the same as the value that any notice pay would be. So if notice pay would be £27,500, then make the ex gratia payment £30,000 or £25,000. This is different enough so as not to be considered to be one and the same thing.
Where you have a ‘payment in lieu of notice’, or ‘PILON’ clause in your contract of employment, this entitled your employer to pay you off instead of making you work your notice period. In this situation, your employer can’t pay your notice pay ‘ex gratia’ because you are entitled to it under the contract, rather than receiving is as a favour. There is more about this technical area on our Payment in Lieu of Notice page.
Ex gratia redundancy payments
In redundancy situations, any statutory redundancy pay and any lump sum can be made into an ex gratia payment in a settlement agreement. There is no obligation to give an ex gratia payment, but it is quite common to do so because both sides want to bring the employment to an end quickly and with the minimum of fuss. For example, it might take your employer a month to go through a consultation process with you, after which its still a foregone conclusion that you will be made redundant, so they might offer you a months’ money ‘ex gratia’ just to save them the time and effort of being seen to go through the motions. Just because there is a consultation it doesn’t mean that this will make a difference to the outcome! A lot of companies make the decision first, and then justify it on paper afterwards. This means that even if you have under two years’ employment under your belt, so you don’t have any unfair dismissal rights (and therefore can’t really complain about an unfair redundancy process), if you play your cards right you could still walk away with a month or so’s money ‘ex gratia’.
Ex gratia payments over £30,000
In relation to any sums over £30,000, the tax-free status is harder to achieve. One way to not pay tax on any amount over £30,000 is to pay it into a pension. Unfortunately this may lock in most of the capital, and so may be favoured more if you are nearing your retirement. See our article called Pension contributions & tax on lump sums. Another way to do help here is to have your employer pay a portion of the money to your lawyer directly in respect of any legal fees, rather than you receiving the money and then paying tax, and then paying your lawyer after that.
In discrimination cases, it is technically possible for an employer to pay an amount as damages for discrimination, and this is regarded by HMRC as tax free. The problem here is that employers don’t want to make admissions of guilt, and therefore such a settlement agreement structure would take careful wording by an expert legal adviser. This does make sense if you are getting an amount well over £30,000 and there is a discrimination element to your situation.
Tax indemnity clauses in settlement agreements
Virtually all settlement agreements which provide for an ex gratia payment also contain a tax indemnity clause, setting out that the employee is liable to account to HMRC and/or the employer for any unpaid tax, should the taxman cometh. Often we receive frantic calls from clients thinking that they are being stitched up by their employer at the last hurdle, because just when they thought that their ex gratia pay deal had been agreed in principle, they receive the small print in the settlement agreement from HR or legal and it seems to suggest that they will have to pay tax after all. Just to give you an idea, here is an example of such a clause:
The sum referred to in clause 2.1(d) will be paid free from deductions of income tax and national insurance contributions as it is the Parties’ understanding that this payment may be made without deduction for tax under section 403 of the Income Tax (Earnings and Pensions) Act 2003. The Employee shall be responsible for the payment of any additional tax or national insurance contributions.
Other than in respect of any tax and national insurance contributions deducted by the Company (if any), the Employee fully indemnifies the Company against all other taxes and employee national insurance contributions in respect of the ex gratia payment and further in respect of all costs, claims, demands, charges, expenses, penalties and interest reasonably incurred by the Company arising out of or in connection with any liability to pay (or deduct) tax or employee national insurance contributions in respect of the ex gratia payment made under this Agreement. The Company will give the Employee: reasonable notice of any demand which may lead to liabilities on the Employee under this indemnity; provide reasonable access to any documentation the Employee may reasonably require to dispute the claim; and allow the Employee a reasonable opportunity to challenge any demand before any payment is made (provided that nothing in this paragraph shall prevent the Company from complying with its legal obligations to HM Revenue and Customs). For the avoidance of doubt the Employee will not be responsible for any payment or liability that has occurred because of the delay or default of the Company.”
Fear not, such a clause is almost always inserted due to custom and practice, and has no bearing on whether you would actually have to pay any tax or not. The thinking behind such clauses (which are in nearly every settlement agreement we see) is that if the Chancellor changes the tax laws so as to mean that ex gratia payments are no longer tax free, then the employer’s back is covered by this clause. In practice, tax laws are never implemented retrospectively, so there is almost no chance that such a clause will ever be called into use.
Instructing us to negotiate a more tax-efficient deal
Unfortunately, a lot of employers are over cautious about tax liabilities and are often unwilling to structure your pay-out in a tax efficient way just in case it leaves them exposed. It can be difficult to approach your HR department with the right arguments and the air of confidence required to help them to structure your settlement agreement in a tax efficient way. This is where it can be beneficial if you instruct specialist lawyers (like us!) who can try to work out a deal with your employer which at least gives them a bit more motivation to get it right for you.