Calculating tax on settlement or compromise agreements can be a difficult task. In this article we explain how to work out how much tax you will pay on any ex gratia settlement amount in excess of £30,000 and then set out a worked example. This article is not for the faint-hearted and it may be of more use to your accountant than to you directly, but we believe you should have the opportunity to consider it at least. Remember, if you want to find out how much your claim is worth try our free Settlement Agreements Calculator.
The basic rules
Employers must use the 0T tax code (rather than BR) in relation to ex gratia payments over £30,000 which are not included in your P45. This could apply if for example you are dismissed, issued with a P45, and then your lawyer negotiates a high settlement for you by way of a settlement agreement.
The regulations state that the 0T tax code is to be applied on a “non-cumulative” basis. For an employee paid on a monthly basis, this means that only 1/12th of the basic rate band (and, if relevant, 1/12th of the higher rate (40%) band) is available in the month of payment.
So, if the termination (or other) payment is more than the appropriate proportion of the 20% band, the excess will be taxed under PAYE at 40%, and if the payment is also more than the available 40% band, the excess will be taxed under PAYE at 45%
Firstly, the employer will have to operate PAYE on the basis that none of the personal allowance is available.
Secondly, “monthly” means tax, rather than calendar, months. Tax months run from the 6th of one calendar month through to the 5th of the next (as each tax year starts on 6 April). This means that payments made on, say, the 7th of one calendar month and the 2nd of the next would fall within the same tax month, with the effect that only one month’s bands would be available to share between the two payments.
Finally, there is a risk that the amount of PAYE deducted is more than the actual income tax liability. If you have little other taxable income in the tax year, you could have too much PAYE deducted from the termination payment and have to reclaim some tax through your tax return.
Top TipsChris Hogg
If you are receiving no other income in the month it may be preferable be paid before your P45 is issued
Consider filing a tax return to ensure you don’t end up overpaying tax
Take specialist advice on your position
Worked example of calculating tax
For example, the PAYE that has to be applied to any post-P45 payment in the first month of the 2018/19 tax year (month 1) will be roughly as follows:
- The first £2,875 or the whole payment if it is less than this amount, is taxed at 20%, which means a PAYE deduction of up to £575 (£2,875 is the 20% band for 2018/19 for month 1, found by dividing by 12 the 20% band for the year, £34,500).
- The next £9,625 is taxed at 40%, which means a PAYE deduction of up to £3,850 (£9,625 is the 40% band for month 1, found by dividing by 12 the 40% band for the year, £150,000 – £34,500).
- Any amount above £12,500 is taxed at 45% (£12,500 is the combined 20% and 40% bands for month 1, found by dividing £150,000 by 12).
This would mean that if, after the issue of the P45, an ex-employee receives a termination payment:
Of £10,000, £3,425 would be withheld as PAYE. The PAYE is calculated as follows:
- 2,875 @ 20% = 575
- 7,125 @ 40% = 2,850
Of £20,000, £7,800 would be withheld as PAYE. The PAYE is calculated as follows:
- 2,875 @ 20% = 575
- 9,625 @ 40% = 3,850
- 7,500 @ 45% = 3,375
The relative merits (from a cash-flow perspective) of pre- or post-P45 payment will need to be assessed individually in each case. However, if an employer makes more than one post-P45 payment to an employee in a tax year, each separate payment will be subject to PAYE independently, and it will not take account of the earlier payments when working out PAYE on the later payments, paid in a different month.
However, the key date is when the employee becomes entitled to the amount: simply delaying payment of portions of an amount to which the employee is already absolutely entitled will probably make matters worse as the employer will have to account for PAYE on the full amount on the date of entitlement.
This appears to mean that if a termination payment is paid in a series of monthly instalments then each instalment would be treated in the way described above, and so could be brought (at least in part) within the monthly non-cumulative 20% band (or 20% and 40% bands).
In addition, there may be a cash-flow advantage for an additional rate taxpayer, who does not get a personal allowance in any event and who is likely to suffer tax on a pre-P45 termination payment entirely at the additional rate (assuming that in the tax month of payment, the employee has already received salary payments that has used up the basic and higher rate allowance).
If the payment is made in a subsequent tax month, and following the P45, an additional rate taxpayer will get another chunk of basic rate and higher rate allowance because of the 0T calculation, and this won’t be reversed until the taxpayer completes a self-assessment tax return for the relevant tax year.