What is a settlement agreement?

A settlement agreement (or a compromise agreement in Northern Ireland) is a legally binding contract entered into by an employer and worker who are in dispute over one or more issues arising out of their employment relationship.

It is used to settle any disputes that would otherwise have to be settled by an employment tribunal or court. They may be used, for example, to settle claims of unfair dismissal, discrimination or unlawful deductions from wages.

A settlement agreement is usually agreed before a worker's employment is terminated. Sometimes, though, they are agreed afterwards, including after a court or tribunal claim has been started, and can be agreed at any time until the judgment.

A settlement agreement will usually provide compensation. In return, the worker will agree not to pursue certain legal claims that they may have against their employer relating to their employment and its termination, as well as agreeing to any further conditions that the employer may impose.

However, there are some potential claims that cannot be included in a settlement agreement, such as:

• personal injury claims that the worker isn't yet aware of yet;
• accumulated pension rights; and
• some employment claims (though these employment claims can be excluded if you use Acas's COT3 agreement).

Legal requirements

Before a settlement agreement can be legally binding, there are several conditions that must be met, including that it must:

• be in writing;
• relate to a current complaint or legal court/tribunal claim; and
• identify a relevant independent adviser who will advise the worker about the terms and effect of the proposed settlement agreement (e.g. a qualified solicitor).

See our Settlement agreement document for more details of what's needed and who can be classed as a relevant independent adviser.

Key elements

The contents of a settlement agreement will depend on the circumstances. You may need to include terms that:

• settle all current and future (unknown) legal claims, allegations and/or complaints against you and state how much will be paid in compensation for doing so (the types of claim must be listed out; a general reference to all potential claims might not work);
• pay any outstanding sums you owe under the terms of their contract, such as salary and pay for notice and untaken holiday;
• confirm you will provide a suitable reference (note that agreeing a falsely complimentary reference in order to get rid of the claim is inadvisable);
• ensure they won't use or disclose any of your confidential information. Note this must not be used inappropriately, for example, by deterring the worker from making protected disclosures (whistleblowing) or alleging misconduct to regulatory bodies.

Tax

An employer can make 2 different types of payment to an employee under a settlement agreement:

• Payment of earnings
• Termination payment

Payment of earnings will be taxable in the usual way, but the first £30,000 of a termination payment is tax free. Any amount over this will be taxable.

Tax will still be payable if the termination payment includes payment for:

• a contractual term, for example, payment for unused holiday; or
• unworked notice periods, whether or not the contract gives the employer the right to pay in lieu of notice. This is referred to as post-employment notice pay (PENP). See HMRC's internal manual for details of working how much PENP should be paid and how to calculate it.

Tax will not be payable if the termination payment includes:

• compensation for personal injury; or
• payment of the employee's legal costs (i.e. the cost of getting legal advice on the settlement agreement), as long as certain rules are followed.

Tax relating to termination payments can be complex and you should get legal advice if necessary.