This guide covers:
- What is an ex gratia payment?
- Can I get an ex gratia payment in my settlement agreement?
- How to negotiate an ex gratia payment
- Are ex gratia payments taxable?
- Why are there tax breaks with ex gratia payments?
- Ex gratia payments up to £30,000 are not taxable
- Tax on ex gratia payments over £30,000
- Can I get an ex gratia payment if I’m made redundant?
- Discrimination compensation and ex gratia payments
- Tax indemnity clauses in settlement documents
What is an ex gratia payment?
‘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.
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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;
Notice pay can no longer be tax free but it is open to the parties to vary the notice period.
Can I get an ex gratia payment in my settlement agreement?
Ex gratia payments are commonly included in settlement agreements. An ex gratia payment in a settlement package 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.
How to negotiate an ex gratia payment
The negotiating ploys and bargaining chips you need for negotiating an ex gratia payment – which is part of a settlement agreement – are much the same as those which you would use to negotiate a settlement agreement overall.
They are outlined further in our practical guides on negotiating a settlement agreement and 15 tips on how to negotiate a settlement agreement.
To summarize here, some or all of the following can help, but don’t put them all on the table at once. Keep a few in reserve so that you can use them as and when you make progress with your negotiations.
In return for that ex gratia payment, you can offer not to do something that you would be justified in doing, and which would cost them time and money if you went ahead. For example, you could offer:
- to withdraw your plans to raise a grievance, (when circumstances suggest you would have grounds for raising a grievance);
- to resign instead of going through time-consuming performance improvement procedures (PIP) that you may be facing;
- not to take any claim you may have against your employer to an employment tribunal (although don’t actually mention tribunals unless it’s on a without prejudice basis)
You can also offer your employer something positive (for them) that you think they want, such as:
- you resigning and leaving quietly (if you think that’s really what they want) with a settlement agreement
- signing a confidentiality clause as part of your exit package which prevents you from going public on any dubious or illegal business practices that you know about in your organization.
- agreeing to the inclusion of restrictive covenants (aka non-compete clauses) in your settlement that will stop you doing such things as poaching your employers customers or setting up a competing business (but make sure that they are not over restrictive!)
- offering to agree to a ‘non derogatory comments’ clause which protects your employer against you making negative comments about them and causing them reputational damage. (But make sure that it’s mutual too so that your employer undertakes to give you the same protection.)
Are ex gratia payments taxable?
As a general rule, ex gratia payments of up to £30,000 are not taxable, but ex gratia payment of £30,000 are subject to both income tax and (from April 2020) national insurance contributions. See below for further information.
Why are there tax breaks with ex gratia payments?
The ex gratia tax break was brought in by government to encourage employers and employees to settle any disputes early and to avoid having to go to court for settlement.
Remember that the government pays for employment tribunals, including judges’ salaries and the courtrooms and so on, and this is expensive. Therefore it makes sense to keep costs down by offering tax breaks for early (out of court) settlement.
It is also worth bearing in mind that if you go to an Employment Tribunal and win a claim there, you don’t get any kind of 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 £24,000).
Ex gratia payments up to £30,000 are not taxable
For such non contractual payments as ex gratia 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.
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.
To calculate roughly how much your ex gratia payment should be, try our Calculator. You might also want to read more in our guides listed at the end of this article, and particularly on how much money you should get and the tax implications of settlement agreements.
Tax on ex gratia payments over £30,000
For 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 on pension contributions and 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, paying tax on it, and then paying your lawyer after that.
Note that from April 2020, an employer is required to pay national insurance contributions on any part of a termination payment that exceeds the £30,000 threshold.
The government has presented this as a payment which comes out of the business’s coffers, rather than as disadvantaging the employee who’s leaving.
However, in practice the employer may try to pass on the cost to employees who are leaving, by reducing the amount of the settlement offered.
Can I get an ex gratia payment if I’m made redundant?
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 redundancy 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 month’s 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 as an ‘ex gratia’ redundancy payment.
Please note, however, that your contractual notice pay cannot be paid ‘ex gratia’ (or tax free), and the HMRC tax provisions mean that you cannot agree to shorten your notice period (and related pay) and increase the ex gratia payment accordingly.
Discrimination compensation and ex gratia payments
In discrimination cases, there is an element of compensation for injury to feelings and in serious cases there may also be damages for psychiatric damage for personal injury.
Under financial legislation effective from 2018, the government devised a new kind of tax exclusion called the “Disability Exemption.”
This applies where an employee receives compensation for impairments caused by a psychiatric injury (as distinct from compensation for injured feelings, unless the latter amount to a psychiatric injury.)
The legislation gives total tax exemption for termination payments made because of the employee’s disability or injury where it prevents the person afflicted from fulfilling their employment duties.
It will be interesting to see how this legislation works out in practice, but we do envisage that it will be difficult for employees to prove their case.
Tax indemnity clauses in settlement documents
Virtually all exit packages 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.
Sometimes 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 study the small print in the 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:
Example of a tax indemnity clause
‘1.1. 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.
‘1.2 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.’
Advice on tax indemnity clauses
Don’t worry, 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.