Employment Knowhow: Settlement agreements

Settlement agreements (or compromise agreements as they are still known in Northern Ireland) are legally binding contracts made between employee and employer. Typically they are used formally to agree the terms on which the employment relationship will end. The employee agrees to waive the right to bring claims against their employer in return for receiving something of value – typically a compensatory payment, but potentially a non-financial benefit such as an agreed reference. This achieves certainty and a clean break for both parties. 

Less commonly, settlement agreements can also be used to settle disputes or potential claims without the employment relationship coming to an end. For example, a settlement agreement may be needed to resolve an under-payment of holiday pay.

The employee must receive independent legal advice on the terms and effect of signing the agreement for it to be legally binding. It is customary – although not a requirement – for the employer to make a contribution to the employee’s fees in obtaining that advice. It is also important for employers to seek legal advice when drafting and negotiating the terms. Recycling an old agreement is not recommended as settlement agreements must comply with certain statutory provisions in order to be valid, and statutory references therefore need to be kept up to date.

Important points that should be included in a settlement agreement are:

  • Termination date – where an employee has a lengthy notice period, consideration should be given as whether he/she should go on garden leave or be made a payment in lieu of notice for part or all of this period.
  • Compensation for benefits – the employee may be giving up potential entitlements to a future bonus or commission payments, deferred stock options or share awards or benefits in kind such as medical insurance or a company car.
  • Taxation – the employee will want the financial package to be structured in as tax efficient way as possible. In most cases the employer will therefore require an indemnity from the employee in the event of tax becoming payable on any sum which is paid tax-free. In most circumstances a payment of up to £30,000 can be made tax-free on the termination of an employee’s employment, provided that it is not a payment under the employee’s contract. However, be aware that from 6 April 2018, all “post-employment notice pay” will be subject to deductions for income tax and NICs even where there is no express PILON clause in the contract (for more detail, see our Insight article here). Other tax efficient options (such as payments into the employee’s pension, a higher contribution to the employee’s legal fees and providing outplacement support) should be considered.
  • Job reference – the employee is likely to want to agree a favourable reference as part of a settlement agreement. For the employer’s part, they must avoid writing anything which is factually incorrect or likely to mislead a future employer.
  • Announcement – particularly in the case of an acrimonious or high-level departure it is sensible to agree internal and/or external announcements in order to reduce the potential for reputational damage on both sides.
  • Restrictive covenants – if the employee already has restrictions written into their contract of employment preventing them from competing with the employer, soliciting clients or poaching employees (see Restrictive Covenants) these can simply be affirmed in the settlement agreement. Settlement discussions present a good opportunity, however, for it to be agreed that restrictive covenants should to be tightened or loosened as required by the negotiating parties. If the employee is being expected to enter into more onerous covenants than his/her pre-existing commitments then compensation should be given for this. Compensation which is for entering into new covenants will be taxable, and should therefore be separately stated within a settlement agreement where there is a tax-free compensatory sum also being paid.

This page was updated on the 1st August 2018.

This information is necessarily of a general nature and doesn’t constitute legal advice. This is not a substitute for formal legal advice, given in the context of full information under an engagement with Bates Wells.

All content on this page is correct as of October 24, 2018.