Agreements between employees and employers on termination of employment (notably compromise agreements under Employment Rights Act 1996 s.203) often contain a full and final settlement clause under which the employee agrees to accept a cash lump sum in return for giving up any claims he may have arising from his employment or its termination. The basic tax position is that the first £30,000 of the cash sum is free of tax (see notes at Compensation/tax on ).

However the £30,000 exemption does not apply if and to the extent that the cash sum is not in settlement of claims but is in return for other consideration, typically that the ex-employee is agreeing to be bound by new restrictive covenants. Almost invariably the ex-employee agrees not to sue the employer. That agreement not to sue is itself a form of restrictive covenant (regardless of any other restrictive covenants in the agreement) and therefore if any of the cash sum is attributable to that it will be taxable under Income Tax (Earnings and Pensions) Act 2003 ss.225-6 (formerly ICTA 1988 s.313).

The general practice of the Inland Revenue has been to accept that payments made pursuant to a compromise agreement do not include any value attributable to the employee agreeing to be bound by restrictive covenants, including specifically the agreement not to sue the employer, unless the circumstances make this clearly wrong. In some cases, tax inspectors have taken the view that the circumstances do make this clearly wrong if there is a repayment clause in the compromise agreement, that is a clause under which the ex-employee is obliged to refund the whole or part of the cash sum he has received in the event that he infringes the restrictive covenants (eg by suing his ex-employer). Some tax inspectors have argued that it must follow that the refundable element, which could be 100%, was in return for the ex-employee agreeing to be bound by a restrictive covenant and that therefore it is taxable under Income Tax (Earnings and Pensions) Act 2003 ss.225-6.

The Inland Revenue have now confirmed that, following legal advice, this argument is normally not sustainable. Accordingly they will only seek to refuse a claim for the £30,000 exemption in exceptional cases in which "..... it may appear that the sum paid under the agreement is excessive in the context of the claims being settled. Where that is the case it may be that part of it should be attributed to the undertaking not to pursue claims, even though there is no specific attribution in the agreement" (see HMRC notes EIM03606 - Restrictive covenants: compromise agreements superceding HMRC Tax Bulletin 67 of November 2003).

See also notes at Compensation/tax on and/or Compensation/tax on/restrictive covenants .