Ex Gratia Payments
What is an ex gratia payment and how can I get one?
‘Ex gratia’ is Latin for “out of good will.” Ex gratia payments in settlement agreements are great things if you can get them, because they offer a unique tax break only really available to employees who are leaving work after a dispute or redundancy situation.
Ex gratia payments are also known as ‘golden handshakes’ or ‘golden boots’. In essence they refer to a sum of money paid when there is no obligation or liability to pay it. For example, a lump sum payment over and above the pension benefits of a retiring employee.
Top 3 TIPS
- The first £30,000 of your ex gratia payment should be tax free;
- You can ask for any redundancy consultation period pay to be paid ex gratia instead; and
- Notice pay can no longer be tax free but it is open to the parties to vary the notice period.
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 of goodwill from your employer because they have treated you badly and acknowledge that you deserve some financial compensation. It may also be a way to avoid you trying to sue them in an Employment Tribunal.
Ex gratia payment tax breaks
For such non contractual payments, there is a tax break whereby up to £30,000 is not subject to income tax or National Insurance deductions. Your employer just pays you the ex gratia payment, and then at the end of the tax year you may be asked to 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, for example your salary, notice, 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 as long as the total sum is under £30,000.
It should be noted, from April 2019, a termination payment will attract employer’s National Insurance contributions. Whilst the Government has sought to spin this as an additional burden on the business rather than the departing employee, we would be concerned that it may reduce the payments that employees receive.
It is worth bearing in mind that 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 in our article How Much Money Should I Get?.
Ex gratia and notice periods
Until changes to the legislation in April 2018, there was a grey area regarding ex gratia payments if they included an element of notice pay. If your contract entitled you to one month’s notice, then theoretically your employer could structure a settlement agreement so that you effectively received this tax free. They could have said ‘we are terminating your employment without notice’, thus technically breaching your contract, and then paid you an ex gratia payment instead. The legislation changed in April 2018, now employers must account to the HMRC for any payment made in respect of notice. This means tax and National Insurance contributions must be deducted by the employer.
You could argue that the ex gratia payment should be increased to take account of the additional tax payments. Or a cheeky alternative could be to vary the notice period from example three months to one month and then increase the ex gratia sum.
One way to calm employers’ nerves about this tax risk (as they see it) is 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. 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 it’s 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 less than two years’ employment under your belt, meaning you don’t legally have any unfair dismissal rights (and therefore can’t really complain about an unfair redundancy process), you may still be able to walk away with a month’s worth of salary 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 avoid paying 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 round this problem 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, there will be an element of compensation for injury to feelings and in serious cases there may also be damages for psychiatric damage for personal injury. Under the Finance Act 2018, the government have introduced changes and now defined a new category of tax exemption. The “Disability Exemption” will apply where an injured employee is compensated for damages resulting from a psychiatric injury that is beyond compensation for hurt feelings and where the person is prevented from carrying out their employment.
This is new law and it will be interesting to see how this works in practice. It may be necessary to produce medical evidence to confirm the injury suffering but this is something that we can offer guidance on to ensure that you receive the right compensation in the most tax advantageous.
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 the HR department yourself with the right arguments and the air of confidence required.This is where it can be beneficial for you to instruct specialist lawyers who can work out a deal with your employer, and help them structure your settlement agreement in a more tax efficient way.