If an employee enters into a 'restrictive undertaking' on termination, any payment for doing so is fully taxable. As well as new restrictive covenants, a restrictive undertaking can include some of the standard confidentiality and non-disparagement provisions in settlement agreements and COT3s.
Tax on termination payments
Where a payment is made, or benefit provided, to an employee on the termination of employment, it is important to assess the basis on which it is made and all the background circumstances to determine the correct tax treatment under the Income Tax (Earnings and Pensions) Act 2003 (ITEPA). HMRC recommends considering these questions in the following order:
- Does the payment or benefit constitute earnings and fall to be taxed in full under section 62 ITEPA?
- If not, is the payment for a 'restrictive undertaking' (see below) and so fully taxable under sections 225 and 226 ITEPA?
- If not, is the payment taxable under sections 401 to 416 ITEPA? These sections are charging provisions for termination payments which cannot be charged to income tax in any other way. Payments and other benefits received in connection with the termination of employment which fall within sections 401 to 416 can be made tax free up to £30,000, with the excess subject to income tax. Employer national insurance contributions (NICs) are also due on any balance over £30,000.
Some payments made on termination are exempt from income tax and NICs, for example (i) outplacement counselling; and (ii) compensation for injury to feelings arising from discrimination which is not related to the termination of employment.
What is a restrictive undertaking?
'Restrictive undertakings' include any new restrictive covenants the employee is entering into on termination but not, according to HMRC Statement of Practice 3/96, a restatement in the settlement agreement / COT3 of any existing restrictive covenants. Restrictive covenants include:
- A non-compete clause (see our earlier blog for details of the proposed new 3-month time limit for non-compete clauses)
- A non-solicitation covenant preventing the former employee from poaching clients, suppliers or customers from the former employer
- A non-dealing covenant preventing the former employee from dealing with clients, suppliers or customers of the former employer (regardless of which party approached the other)
- Non-solicitation of employees
- Restrictions on using confidential information.
A 2022 decision of the first-tier tax tribunal clarified that any undertaking which restricts an individual’s conduct or activities, whether related to their employment or personal lives, which is given in connection with their current, future or past employment is a 'restrictive undertaking' falling within section 225 (Mrs. A v HMRC 2022 UKFTT 421). This is wide enough to include obligations on an employee (i) to keep the fact and terms of the termination of employment and settlement confidential; and (ii) not to make detrimental or derogatory statements about their former employer or its employees.
Settlement agreements and COT3s
It is common for settlement agreements and COT3s to include these type of confidentiality and non-disparagement clauses. An employee may also agree to new restrictive covenants as part of their settlement terms.
A payment made to an employee on termination in return for agreeing to a restrictive undertaking is subject to income tax and NICs in full. It is important, therefore, to ensure that any compensation under a settlement agreement / COT3 intended to be treated as a section 401 termination payment (and paid tax free up to £30,000) is not treated as payment for a restrictive undertaking. A sum should be allocated directly to any restrictive undertaking the employee is agreeing to (which is taxed in full), otherwise there is a risk that HMRC will tax the whole compensation payment.
For more information, or assistance with drafting or reviewing settlement terms, please get in touch with a member of the Employment and Immigration team.
Users of Workbox by Brodies, our award-winning HR and employment law site, will find guidance at the pages on Settlement Agreements (where there is a template agreement and drafting notes), Employee Restrictions and Tax on Termination Payments.