Settlement Agreements: Protections, Tax, and Negotiation

Settlement agreements are private contracts terminating an employment dispute. They are used in three main scenarios:

• Mutual exit — the employer and employee agree termination with a financial package; no fault is alleged.
• Disciplinary or grievance resolution — a dispute is resolved with payment instead of a final formal outcome.
• Tribunal claim settlement — a claim already filed at the Employment Tribunal is settled (often through ACAS, in which case the COT3 agreement is used instead of a settlement agreement).

The settlement agreement is the standard tool for amicable employment exits in the UK. Without one, the employee can later claim at the Tribunal even if they accepted a sum on departure — the law specifically requires the formal agreement to make the waiver effective.

Under section 203(3) ERA 1996, a settlement agreement is only effective if:

• It is in writing.
• It relates to the specific claim or claims being waived (each claim listed by reference to the underlying legal right).
• The employee has received advice from a relevant independent adviser about the terms and effect of the agreement, particularly its effect on the employee's ability to pursue claims.
• The adviser is named in the agreement and has a current contract of insurance or professional indemnity covering the advice.
• The agreement states that the statutory conditions have been satisfied.

An "independent adviser" is a solicitor, a qualified union officer or representative, a Citizens Advice adviser, or other appropriately qualified person. Most settlement agreements involve a solicitor; this is standard and the employer almost always pays the solicitor's fee.

Section 111A ERA 1996, introduced in 2013, allows "pre-termination negotiations" to take place on a confidential basis. Conversations and offers made for the purpose of settling a possible departure cannot be referred to in an unfair dismissal Tribunal claim. This is broader than the older "without prejudice" rule, which only applied where a dispute already existed.

Section 111A protection is automatic for negotiations specifically about exit and a settlement agreement. But the protection has limits: it does not apply where the employer has acted "improperly" — including by using undue pressure, putting the employee in fear of dismissal without giving them a fair chance to respond, or threatening legal action when none is justified. Tribunal cases have included examples where Section 111A was lost because the employer set artificially short deadlines or threatened summary dismissal.

Section 111A applies only to unfair dismissal claims. It does NOT protect against discrimination claims or other claims — those still fall under the older "without prejudice" rule, which has different (narrower) requirements.

Settlement payments have specific tax rules:

• Termination payment up to £30,000 — tax-free under section 401 ITEPA 2003. Above £30,000, income tax at your marginal rate; employer NIC also applies (since April 2020).
• Notice pay (PILON — payment in lieu of notice) — always taxable as earnings, regardless of whether it is structured as part of the settlement.
• Statutory redundancy — counts towards the £30,000 tax-free amount.
• Holiday pay and bonus — taxable as earnings.
• Compensation for injury to feelings — generally taxable if for discrimination during employment; tax-free if for personal injury (Moorthy v HMRC [2018]). Get specialist advice on this point.
• Restrictive covenants — sums paid for entering into post-termination restrictive covenants are taxable.
• Legal fees paid by employer — not a taxable benefit if paid directly to your solicitor for advice on the settlement agreement.

The agreement should specify which sums fall under which heading. Disputed sums later often turn on whether they were properly attributed at the time.

Five points to negotiate:

1. Increase the termination payment. The opening offer is rarely the final one. Ask for at least 50% more than offered. Senior employees with strong unfair dismissal claims often achieve 6-12 months' salary.
2. Get an agreed reference. A factual reference (start date, end date, role) is standard. A positive reference is negotiable. The reference wording should be in the agreement.
3. Confidentiality and non-disparagement should be mutual. Many drafts have the employee bound but not the employer — push for symmetry.
4. Carve out personal injury claims. Standard waivers cover known claims. Future personal injury (e.g., stress-related illness developing post-departure) should be specifically excluded.
5. Restrictive covenants. The agreement may seek to re-impose or extend non-compete clauses. Push back on any that are wider than your existing contract or genuinely necessary.

The negotiation is usually conducted between your solicitor and the employer's HR or legal team. Most agreements complete within 2-4 weeks of opening discussion.