Termination of employment: Taxation of employee`s legal costs

When an employee`s contract is terminated there often is a settlement negotiated between the employer and employee. That is a sensible thing to do. It provides certainty to the employer that there will be no further claims against it, for example for unfair dismissal. It gets cash into the hands of the employee relatively quickly and allows the employee to get on with the rest of his working life.

In order to be legally enforceable the terms of the deal must be contained in a formal legal document called a "compromise agreement". The compromise agreement must covered specific issues and the employee must receive independent legal advice upon it.

As part of the deal, the employer often agrees to pay the employee`s legal costs. Is that not a benefit in kind and therefore subject to income tax and national insurance contributions (NICs)? No, provided the compromise agreement is properly drafted. The exemption from income tax has been around for a long time. It was contained in an extra statutory concession and, as part of the general move to put all extra statutory concessions on a statutory basis, was incorporated into tax legislation on 6 April 2011.

Unfortunately, the exemption does not cover other advisers` fees. If an accountant had been advising the employee on his termination of employment, then payment of his fees by the employer would be a taxable benefit.

There is no ability for the employer to reclaim the VAT on the employee`s adviser`s costs. That is because, in line with general VAT rules, the services are being provided to the employee, not the employer.

If you have any questions on tax, please contact Nasim Sharf on 01482 337336, email nasim.sharf@rollits.com. For any employment law queries, please contact Donna Ingleby (donna.ingleby@rollits.com) or Ed Jenneson (ed.jenneson@rollits.com) in the Employment Team. 

Posted on: 13/10/2011

This article is for general guidance only. It provides useful information in a concise form. Action should not be taken without obtaining specific legal advice.

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