Law guide: Employment

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Settlement agreements

Settlement agreements

Why might you need a settlement agreement?

If you have a dispute with an employee, a settlement agreement is one option that may be available for you to resolve it.

There are other options you may want to consider before using a settlement agreement briefly outlined as follows:

1. You could continue trying to resolve the matter so as to maintain the employment relationship.

2. If the employee, or perhaps former employee, does bring a tribunal claim, you could defend the matter. If you've acted fairly the whole time, then you should be able to defend any claim they may bring. This might demonstrate that you have confidence in your actions and provide a detriment to other future claims by other employees. But note that there is always a risk in litigation – your witnesses might come across badly and the tribunal might find against you.

3. In England, Wales and Scotland, you might enlist the help of the Advisory, Conciliation and Arbitration Service (Acas), or in Northern Ireland the Labour Relations Agency (LRA). They can help settle disputes and will draft the terms into a conciliated agreement (called a COT3 by Acas). Normally, this route only happens after an employee has contacted Acas or the LRA to say they intend to bring a claim.

4. Employers in England, Wales and Scotland who believe that an employee could start a claim for unfair dismissal against them (due to some action they are about to take) can have a 'protected conversation' with them. These are 'out of the blue' discussions with a view to terminating their employment using a settlement agreement. Neither of you will able to rely on the details of the conversation as evidence in any unfair dismissal claim.

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 employee 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 sometimes agreed before the termination of the employee's employment, but sometimes they are agreed after termination or after a claim has been issued at a court or tribunal – they can be agreed at any time until the tribunal gives judgment. A settlement agreement will usually provide the employee compensation. In return, the employee will agree not to pursue any legal claims that they may have against the employer relating to their employment and its termination (as well as agreeing to any further conditions that the employer may impose).

There are, however, a small number of potential claims that cannot be contracted out of, in particular, personal injury claims that the employee isn't yet aware of and accrued pension rights. In addition, certain claims cannot be contracted out by a settlement agreement, but can be covered by a COT3.

Legal requirements

Before a settlement agreement can be legally binding, the following conditions, which are set out in several pieces of legislation, must be met:

a) The agreement must be in writing.

b) The agreement must relate to a particular complaint or legal proceedings made, raised or instigated by the employee.) The agreement must identify a 'relevant independent adviser' from whom the employee has received legal advice as to the terms and effect of the proposed agreement and, in particular, its effect on their ability to pursue a claim before a tribunal or court.

c) The agreement must state that these conditions regulating settlements have been satisfied.

The following can be classed as relevant independent advisers:

  • Qualified lawyers (solicitors holding a practising certificate or barristers in practice or employed to give legal advice)
  • Officers, officials, employees or members of an independent trade union, provided they have been certified in writing by the union as competent and authorised to give advice
  • Employees or volunteer workers at advice centres giving free legal advice provided they have been certified in writing by the advice centre as competent and authorised to give advice
  • (In England & Wales) Fellows of the Institute of Legal Executives employed by a solicitors' practice
  • (In Northern Ireland) A person of a description specified in an order made by the Department for the Economy

When the relevant independent adviser gives the legal advice, there must be an insurance contract in force, or an indemnity provided for members of a profession or professional body, covering the risk of a claim by the employee in relation to the advice.

The agreement must identify the relevant independent adviser.

Essential elements

The contents of a settlement agreement will depend on the requirements of the employer and employee who are in dispute. A good settlement agreement will ensure that an employer's business interests are protected while also making sure that future claims are prohibited.

However, generally the following items should be considered when negotiating a settlement agreement:

a) Settlement of all current and future legal claims, allegations and/or complaints against the employer by the employee and the provision of compensation for doing so. Note, however, that the particular claims must be identified; a general reference to all potential claims might not suffice. It is also considered good practice to give some background to the claims and potential claims.

b) The payment of any outstanding sums that the employer owes the employee under the terms and conditions of their contract. Such sums may include salary, outstanding holiday pay and any bonus they may be entitled to.

c) Provision for the payment of the employee's legal fees.

d) Provision for the employee's resignation (if applicable).

e) An assurance that the employer will provide a suitable reference for the employee (including a template if one can be agreed) – but note that agreeing a falsely complimentary reference in order to get rid of the claim is inadvisable.

f) Provisions that ensure that the employee will not use or disclose any confidential information – however these provisions must not be used inappropriately, for example, by deterring the employee from making protected disclosures (whistleblowing) or alleging misconduct to regulatory bodies.

Tax on settlements

An employer can make two different types of payment to an employee under a settlement agreement: the payment of earnings and a termination payment. Payment of earnings will be taxable in the usual way, but special considerations apply to termination payments.

The main tax issues that relate to termination payments are that:

1. The first £30,000 of a termination payment is tax free. Any amount in excess of £30,000 will be subject to tax. This will include employer National Insurance contributions but not employee National Insurance contributions.

2. However, where the payment (or part of it) is made under a contractual term, for example, payment for unused holiday, it is taxed as earnings using the employee's own tax rate.

3. In addition, if the termination payment relates to unworked notice, that part will be taxed as earnings. That is the case whether or not the contract gives the employer the right to pay in lieu of notice (PILON). This is referred to as 'post-employment notice pay' (PENP).

Legislation provides calculations for working out how much PENP should be paid. See HMRC's internal manual for details of how to calculate PENP.

4. Compensation for personal injury is not taxable.

5. Compensation for injury to feelings is taxable if it's related to termination of the employment (so the first £30,000 is tax free); if it's not, for example, if it's for something that happened wholly before termination, it's tax free.

6. Payment of the employee's legal costs (i.e. the cost of obtaining legal advice) by the employer will not be taxable so long as certain rules are followed.

For further information on the tax implications and exemptions that relate to settlement agreements, see HM Revenue & Customs

Pre-termination negotiations (England, Wales & Scotland)

Pre-termination negotiations are confidential talks held with employees with a view to ending their employment on agreed terms. By law neither the employer nor employee can use pre-termination negotiations as evidence in an unfair dismissal claim.

This will apply unless either party has shown 'improper behaviour', e.g. harassment, intimidation, assault, victimisation, discrimination or putting undue pressure on a party (such as allowing insufficient time to consider the offer or threatening dismissal if the offer is rejected). See Acas's code of practice for more information.

Pre-termination negotiations can be used as evidence, however, in the following claims:

In addition, communications for the purpose of settling a dispute are called 'without prejudice' and can't be used as evidence in litigation. This is broader than the pre-termination negotiations explained above, as it applies to all types of claims. However, you need a 'dispute' before communications can be considered 'without prejudice'. This can cause problems for the employer when termination is first suggested. A couple of examples may assist:

  • An employee tells you that they're overworked and they intend to resign and bring an unfair dismissal claim. You deny this saying it was just a communication breakdown. You therefore have a dispute. You might then say to them: 'Without prejudice, whilst we don't accept you were overworked, we'll agree to pay you £10,000 as a termination payment.'
  • You've decided that an employee isn't good enough at their job. In this situation, it would be better to say, 'Without prejudice and as a protection conversation under section 111A of the Employment Rights Act, we'll offer you £10,000 as a termination payment.'

In addition, if your correspondence demonstrates unambiguous impropriety it might be admitted to the tribunal and considered as evidence.

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