Drafting settlement agreements is a critical task for HR professionals, as these documents play a pivotal role in resolving disputes and protecting the interests of both employers and employees. However, without quality legal advice, errors in drafting settlement agreements can lead to delays, increased costs and even legal challenges.
B P Collins’ employment team addresses three common mistakes and provides practical tips to avoid them. They include:
- Backdated termination dates where notice has not been given on an open basis,
- Dating the agreement before it has been signed by the parties, and
- Incorrect handling of Payment in Lieu of Notice (PILON), which can create issues with Post-Employment Notice Pay (PENP).
Backdated termination date
Often, settlement agreements from employers include a backdated termination date but notice of termination has not been given on an open basis. The settlement agreement cannot be dated in the past. It does not reflect the reality of the situation that the employee is still employed by their employer.
Backdating termination dates in settlement agreements without providing notice on an open basis creates risks of unenforceability and adverse tax consequences. HMRC may argue that such agreements constitute amendments to the employment contract rather than genuine termination agreements, which could result in the payments being taxed as employment income rather than qualifying for the £30,000 tax exemption.
It is also because settlement agreements may not effectively settle claims arising between the date of the agreement and the termination date, if it is backdated and notice has not been given on an open basis.
Dating the agreement early
This usually transpires as a simple mistake and tends to the date an employee receives the draft settlement agreement. However, incorrectly dating a settlement agreement before it has been signed by all parties can lead to enforceability issues.
For a settlement agreement to be enforceable, it must be correctly executed as a deed or contract. Failure to adhere to proper execution requirements, including ensuring the agreement is signed by authorised signatories, risks rendering the agreement void and unenforceable.
To mitigate this risk, parties should ensure that the agreement is dated only after all parties have signed it.
Incorrect handling of Payment in Lieu of Notice
Pay in lieu of notice (PILON) payments are a common feature in employment termination arrangements, and their tax treatment is governed by the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). The tax treatment of PILON payments has undergone significant changes since 6 April 2018, with all PILON payments now being fully taxable and subject to National Insurance contributions.
Employers must conduct a Post Employment Notice Pay (PENP) calculation to determine the taxable portion of termination payments. If the calculation is not performed correctly, the entire termination payment may be treated as earnings and subject to full taxation, eliminating the possibility of benefiting from the £30,000 tax exemption
Failure to correctly address PILON in the settlement agreement can lead to disputes and unexpected tax liabilities. This is a technical element to the settlement agreement which has to be correct before signing.
Including tax indemnity clauses in settlement agreements can further protect employers from additional tax liabilities, while providing employees with an opportunity to challenge tax assessments. By addressing these issues proactively, employers can minimise risks and ensure the enforceability of settlement agreements.
If you need support with drafting a settlement agreement, or have been asked to sign one, the employment team at B P Collins has a huge level of expertise in this area and would be happy to help. There are many important points to consider, and taking advice early can make all the difference. Please email enquiries@bpcollins.co.uk or call 01753 889995.
