Advice on tax implications in settlement agreements – how Farore Law stands out from the rest

Claimant lawyers often advise clients on the terms of a settlement agreement following their dismissal/removal from employment or partnership, or commencement of legal proceedings. This often does not involve negotiation of the terms. At Farore Law we never sign off agreements without proposing changes to the wording of agreements.  When dealing with senior executives, we also assist our clients with the potentially significant tax implication of the agreement. 

The team at Farore Law will do its best to ensure that the terms of a settlement agreement are favourable to our client, which often includes instructing specialist tax advisers where appropriate.

To illustrate the value that our lawyers provide to senior executives when advising them on the terms of a settlement agreement, this blog provides a case study of a recent LLP dispute in which Suzanne McKie KC and Lucas Nacif negotiated a settlement agreement on behalf of a former partner.

Some facts underlying this case study were modified for confidentiality reasons.

The Case Study

Farore Law had acted for a former LLP partner in a high-value disability discrimination claim. In this case, our client was employed by a service company and was also member of an LLP. The service company and the LLP was ultimately controlled by a Plc, in which our client was awarded a considerable number of shares (subject to a vesting schedule).

Following our client’s dismissal, all her shares were forfeited. The loss of earnings and loss of shares were valued in excess of £10,000,000.

Legal proceedings were issued for disability discrimination, both in relation to her employment and her membership of the LLP. Shortly before a hearing in the case, proposals for settlement were made.

The settlement agreement was unusual, as it involved assigning a number of shares to our client, from an Employment Benefit Trust (“EBT”), which would then be sold on her behalf to fund the settlement sum under the proposed settlement agreement. As such, our client wasn’t being paid directly by her former employer or the former partnership – rather, her employer/EBT would allocate her shares which would then be sold in the market (via a broker) so that the proceeds could be distributed to our client.

The Problem

We were immediately concerned by the tax implications of this settlement agreement. After all, if the Respondents/EBT were going to allocate shares to our client, would this mean that the HMRC would treat the settlement sum as income tax or capital gains tax? 

One concern we had is whether the settlement agreement sums would fall under the employment-related securities provisions at Part 7 of ITEPA 2003, which would have meant that the market value of the shares would be subject to income tax (at 45%) and our client would have also been unable to rely on the exceptions set out at Chapter 3 of Part 6 ITEPA 2003, in which certain types of payment are tax-free (such as receiving a payment on account of disability under section 406 ITEPA 2003).

Although the Respondents were offering a considerable settlement sum, we were ultimately concerned that the settlement agreement posed too many tax risks for our client – which would have been financially disastrous in the long-run if the HMRC ever attempted to challenge the settlement agreement.

The Solution

We recommended our client allow us to instruct a specialist tax adviser to advise her on the tax implications of the settlement agreement, through our network of tax advisory and accountancy firms.   We wanted to work with the tax adviser directly in order to determine ways to amend the draft settlement agreement to ensure it was as tax efficient as possible for our client.

By working closely with the tax adviser, we ensured that the settlement agreement was re-drafted to ensure that it contained express reference to a payment being made on account of disability (to ensure that the tax exception in section 406 ITEPA 2003 applied). But we also wanted to ensure there was a further “fallback” if needed. As such, we also obtained confirmation from the other side that the former employer would be returning shares (previously forfeited) to our client and would not apply PAYE to the settlement sum. This ensured that the employment-related securities provisions in Part 7 of ITEPA 2003 did not apply and means that our client may make use of capital losses (if applicable). 

Should there not have been a “return” of shares, it might well be regarded by the tax authorities as a provision of shares for the first time, which would attract the employment-related securities provisions. If this was the case, the HMRC would tax the market value of the shares at 45% income tax, on the basis that the client provided nil financial consideration for the shares.

By contrast, since the respondent confirmed that they would be returning a substantial portion of her forfeited shares, this enabled her to potentially seek capital gains relief in the future. In particular, when our client was awarded shares in the Plc, she exchanged her equity interest in the LLP for shares in return. This exchange constituted consideration and was, at that time, valued at approximately £10 million. That being so, , she was deemed to have acquired those shares at market value and, as such, the employment-related securities provisions should not apply. Under the settlement agreement, she received a settlement sum in the region of £5 million. As a result, she is free to argue that she is, in effect, suffering a capital loss and is not liable to pay any capital gains tax arising from the sale of these shares (since the return of shares does not fully compensate the true extent of her losses).

Going back to the  s.406 provisions, in the opinion of those involved,  reference in the settlement agreement to the fact that the settlement sums are being paid because of the disability is essential. However, if it may not be necessary for the respondents to agree to specifically say in the agreement that s.406 applies. We would however, always advise that there be brief reference should be made to the medical evidence that underpins the finding of a disability.

Whilst there can never be guarantees regarding the use of the s.406 exemption, we always consider proposing a ‘grossing-up’ of the proposed settlement sum, taking into account any taxes our clients might become liable to once they submit their tax returns, the amount of the grossing up taking it into account the level of risk. The use of an escrow and attempting to receive pre-clearance from HMRC is one route to provide greater assurance. However, in our experience, tax advisers may take the view that this approach brings the matter to the attention of HMRC which may not be in the interests of the client. 

In addition, obtaining pre-clearance from the HMRC is often time consuming and therefore not a commercial route to take where negotiations take place days prior to a hearing.

If s.406 cannot apply, then capital gains tax will apply to the return of any shares. A first-time allocation of shares will attract 45% for the reasons set out above. As such, where there is an argument that shares have been forfeited on an interim basis, pending the outcome of the litigation or otherwise, advisers should try to ensure that it is made clear in the agreement that the shares are being returned to the claimant, as this may enable the claimant to make use of capital gains tax reliefs.

Why us?

Farore Law is a leading boutique law firm that has a wealth of experience in advising senior executives in complex discrimination, whistleblowing claims and partnership disputes. We are well placed to provide appropriate advice in negotiating a settlement on behalf of senior executives, including seeking specialist tax advice to advise our clients on the tax implications of complex settlement agreements.

Unlike some claimant-sided law firms, we actively challenge the terms of a settlement agreement. We do not believe in allowing our clients to quickly sign away their rights. We always fight hard to negotiate the best possible terms in a settlement agreement. This not only includes agreeing on the best possible financial terms, but also ensuring that terms related to waiver of claims, confidentiality, non-disparagement, restrictive covenants and other terms are favourable to our client’s interests.

Please contact us if you require legal advice.