Introduction: Why an Employment Tribunal Settlement Cuts Both Ways
An employment tribunal settlement that your London solicitor has structured beautifully for HMRC can still hand the IRS a five-figure bill you never budgeted for. Furthermore, the parts your solicitor fought hardest to keep tax-free in Britain are precisely the parts America taxes without mercy. This asymmetry catches senior bankers, fund managers and general counsel every year, and it turns an employment tribunal settlement into two separate tax problems rather than one.
The problem is structural rather than accidental. British law exempts several categories of compensation that the Internal Revenue Code refuses to exempt. Consequently, a US citizen or green card holder resident in Britain faces a second assessment on money that bore no UK tax at all. Moreover, the foreign tax credit cannot rescue income that HMRC never taxed, which is why an employment tribunal settlement so often produces a second bill.
At TaxYork we have guided senior professionals through this exact collision for years. Therefore, this guide sets out how each slice of an employment tribunal settlement is treated on both sides of the Atlantic in the 2026/27 year. Additionally, it exposes the legal fee trap that generates most of the American tax bill.
How HMRC Taxes an Employment Tribunal Settlement in 2026/27
British tax law does not treat a settlement as a single sum. Instead, HMRC dissects it into components and taxes each one differently. Accordingly, the drafting of an employment tribunal settlement determines the outcome far more than the headline figure does. Guidance from Acas on settlement agreements sets out the framework employers must follow.
What an Employment Tribunal Settlement Actually Contains
A typical employment tribunal settlement contains four distinct elements. First comes post-employment notice pay, which represents the notice you would have worked. Second comes compensation for loss of office, which is the negotiated exit sum. Third comes any award for injury to feelings arising from discrimination. Finally, the employer often meets your legal costs directly.
Each element carries its own British treatment. Notably, only the second category benefits from the famous £30,000 exemption. Therefore, an agreement that lumps everything together invites HMRC to tax the lot as earnings. In our experience, poorly apportioned agreements cost clients more than the dispute itself.
The £30,000 Exemption and Post-Employment Notice Pay
Section 403 of the Income Tax (Earnings and Pensions) Act 2003 exempts the first £30,000 of a genuine termination award. You can read the exemption in section 403 ITEPA 2003 directly. However, the exemption applies only after post-employment notice pay has been stripped out.
Post-employment notice pay is calculated under a statutory formula and taxed as ordinary earnings. Consequently, it attracts income tax and employee National Insurance in full. HMRC guidance on post-employment notice pay explains the mechanics. Meanwhile, the balance above £30,000 attracts employer Class 1A National Insurance at 15% for 2026/27, as confirmed in the employer rates and thresholds for 2026 to 2027.
Employee National Insurance does not apply to that excess. Importantly, National Insurance is never creditable against US tax in any event. Therefore, American filers should focus on income tax alone when planning an employment tribunal settlement. The Chartered Institute of Taxation publishes technical commentary on termination payments for practitioners.
Injury to Feelings and Section 406(2) ITEPA
Injury to feelings is where British treatment turns genuinely technical. Section 406(2) ITEPA 2003 now states plainly that although injury includes psychiatric injury, it does not include injured feelings. You can read the current wording of section 406 ITEPA 2003 in full.
That subsection was inserted by the Finance (No. 2) Act 2017 and bites on terminations from 6 April 2018. Consequently, injury to feelings connected with the termination itself falls inside the £30,000 pot rather than escaping tax entirely. Nevertheless, an award for discrimination that occurred during the employment, and not in connection with its ending, sits outside employment income altogether and bears no UK tax.
That distinction is worth a great deal in Britain. Correspondingly, HMRC's employment income manual on injury awards sets out the evidential standard. However, the same distinction is worth nothing at all to an American, as the next sections demonstrate. In practice, the injury to feelings line of an employment tribunal settlement is the one we query first.
Vento Bands, Compensation Caps and the January 2027 Change
Quantum drives everything. Therefore, understanding the current award bands helps you predict the shape of any employment tribunal settlement before negotiations begin.
The April 2026 Vento Bands
For claims presented on or after 6 April 2026, the lower Vento band runs from £1,300 to £12,600. Similarly, the middle band runs from £12,600 to £37,700, and the upper band from £37,700 to £62,900. Exceptional cases may exceed £62,900 entirely.
These figures come from the presidential guidance published by the judiciary. Furthermore, they apply to discrimination and whistleblowing detriment claims under the Equality Act 2010. The Employment Tribunal service guidance explains the claim process itself, while the judiciary presidential guidance on injury to feelings awards sets the bands used to value an employment tribunal settlement.
The Compensation Cap and Why It Disappears in 2027
From 6 April 2026 the compensatory award for unfair dismissal is capped at £123,543, or 52 weeks' actual pay if lower. Additionally, the basic award cap stands at £9,157 and a week's pay at £751. These caps rose from £118,223 and £9,000 respectively, and they shape the ceiling of any negotiated employment tribunal settlement.
The Employment Rights Act 2025 removes the compensatory cap entirely from 1 January 2027. Consequently, tribunals will be able to award full loss of earnings without any statutory ceiling. For a City professional on seven figures, that change transforms the arithmetic of an employment tribunal settlement and, by extension, the American tax exposure attached to it.
Where the IRS Disagrees With HMRC
American law starts from the opposite premise. Section 61 of the Internal Revenue Code brings everything into gross income unless a specific exclusion applies. Therefore, the burden falls on you to find an exclusion rather than on the IRS to find a charge.
Section 104(a)(2) and the Physical Injury Rule
Section 104(a)(2) excludes damages received on account of personal physical injuries or physical sickness. Crucially, emotional distress alone does not qualify unless it flows from a physical injury. The IRS states this position directly in its guidance on the tax implications of settlements and judgments.
Injury to feelings is emotional distress by another name. Consequently, a Vento award that Britain treats as entirely tax-free remains fully taxable in America. Moreover, back pay and damages arising from employment discrimination claims are expressly outside the exclusion. IRS Publication 4345 confirms the treatment for settlement recipients of an employment tribunal settlement or any comparable award.
Why the £30,000 Exemption Creates Naked US Income
The £30,000 exemption and a pre-termination discrimination award share one fatal characteristic. Specifically, neither bears any British tax. Therefore, neither generates a foreign tax credit.
Every dollar of an employment tribunal settlement that escapes HMRC lands in the American tax base unsheltered. However, the position is more subtle than it first appears. Where the taxed slices bore UK tax at 45%, and the American marginal rate is 37%, the surplus credit from those slices can often absorb the US charge on the untaxed slices within the same general limitation basket.
That relief has a hard boundary. Once the effective UK rate across the whole settlement drops below the American marginal rate, the credit runs out. Ultimately, the British exemption your solicitor negotiated simply transfers money from HMRC to the IRS rather than saving it.
Interest, Costs and the Net Investment Income Tax
Tribunals frequently award interest on discrimination awards. Interest is investment income for American purposes. Accordingly, it can attract the 3.8% Net Investment Income Tax on top of ordinary rates, and no foreign tax credit reaches that charge.
Grossing-up clauses deserve equal attention. Where an employer agrees to gross up a payment for UK tax, the gross-up is itself taxable income in America. Therefore, the clause protects you in Britain while enlarging your American bill. Every gross-up inside an employment tribunal settlement deserves separate modelling.
The Legal Fees Trap Nobody Warns Americans About
This section contains the single most expensive point in the entire guide. Furthermore, it is the point that UK employment solicitors almost never raise, because it has no British equivalent.
Commissioner v Banks and Gross Income
Section 413A ITEPA 2003 exempts legal costs that an employer pays directly to your solicitor under a settlement agreement or tribunal order. You can read the legal costs exemption in section 413A for the precise conditions. In Britain, therefore, those costs cost you nothing.
America takes the opposite view. Under the Supreme Court decision in Commissioner v Banks, the full recovery enters your gross income even where the fees go straight to your lawyer and never touch your account. Consequently, you are taxed on money you never received, and the effect on a large employment tribunal settlement is severe.
Why Section 62(a)(20) Does Not Reach a UK Claim
Congress anticipated this unfairness. Section 62(a)(20) grants an above-the-line deduction for attorney fees and court costs paid in connection with a claim of unlawful discrimination. However, section 62(e) defines that term by reference to a closed list of statutes.
The residual category, section 62(e)(18), covers any provision of Federal, State or local law regulating an aspect of the employment relationship. Notably, the Equality Act 2010 and the Employment Rights Act 1996 are none of those things. Therefore, a claim brought under British employment law falls outside the definition, and the above-the-line deduction is simply unavailable to anyone receiving an employment tribunal settlement in London.
The Permanent Loss of Miscellaneous Deductions
Before 2018, a fallback existed. Legal fees could be claimed as a miscellaneous itemised deduction subject to the two percent floor. Subsequently, the Tax Cuts and Jobs Act suspended that category for 2018 through 2025.
The One Big Beautiful Bill Act made the elimination permanent from 1 January 2026, preserving only a narrow educator expense carve-out. Consequently, an American who wins a UK discrimination claim now pays federal tax on their solicitor's fees with no deduction of any kind, permanently. This is genuine phantom income, and it drives most of the American cost of an employment tribunal settlement.
Sourcing, the Foreign Tax Credit and the Treaty
Relief depends entirely on characterisation. Therefore, getting the sourcing analysis right determines whether you pay once or twice.
Where a Settlement Is Sourced
Compensation for personal services is sourced where the services were performed. Under the origin of the claim doctrine, damages take the character of what they replace. Accordingly, an employment tribunal settlement replacing wages earned in London is foreign-source income, which is exactly what the foreign tax credit requires.
That conclusion holds for injury to feelings as well. The underlying discrimination occurred in Britain. Consequently, the award sits in the general limitation basket alongside your salary, which matters because credits pool within a basket. Our guidance on foreign tax credit and treaty planning explains how those baskets interact.
Foreign Earned Income Exclusion or Foreign Tax Credit
The exclusion is narrower than most people assume. Only compensation for services qualifies as earned income. Therefore, post-employment notice pay attributable to UK duties can fall within it, while injury to feelings damages never can.
The foreign earned income exclusion rules cap the benefit in any event. For a settlement of this size, the foreign tax credit does the real work. Furthermore, Publication 54 sets out how both interact for Americans abroad who receive an employment tribunal settlement.
Timing Mismatches Between HMRC and the IRS
British tax years end on 5 April while American years end on 31 December. Consequently, a settlement paid in February bears UK tax in one American calendar year and generates credit in another under the cash basis. That mismatch can strand a credit permanently, so the payment date of an employment tribunal settlement carries real value.
Currency adds a second layer. You must translate each element at the appropriate rate, and the IRS yearly average currency exchange rates provide the accepted figures. Meanwhile, the US-UK income tax treaty documents govern which country has the primary claim.
Case Study: A £480,000 Discrimination Settlement in the City
Consider an American managing director at a London investment bank. They brought a discrimination and unfair dismissal claim and settled for £480,000 shortly before the hearing. Their UK solicitor structured the employment tribunal settlement with genuine skill. Professional guidance from ICAEW on tax technical matters supports the analysis below.
How the Settlement Was Structured
The agreement allocated £75,000 to post-employment notice pay and £300,000 to compensation for loss of office. Additionally, it allocated £45,000 to injury to feelings for discrimination that occurred during the employment rather than on termination. Finally, the bank paid £60,000 of legal costs directly to the solicitors.
Britain taxed the notice pay in full at 45%, producing £33,750. Similarly, £270,000 of the loss of office payment was taxed at 45% after the £30,000 exemption, producing £121,500. Therefore, total UK income tax came to £155,250, an effective rate of 32.3% across the whole award.
The American Position on the Same Facts
America included the entire £480,000 in gross income, including the £60,000 that went straight to the solicitors. At an illustrative rate of 1.35 dollars to the pound, that is $648,000. Assuming the client already sat in the 37% bracket and held no unused credit carryforward, the incremental US charge was $239,760.
The creditable UK tax was £155,250, or $209,588, since National Insurance never qualifies. Consequently, the residual American bill came to roughly $30,200 on a settlement the client believed had already been taxed at 45%.
What the Numbers Actually Reveal
Strip the legal fees out of income and the picture changes completely. Had section 62(a)(20) reached a British claim, foreign taxable income would have fallen to $567,000, US tax to $209,790, and the residual charge to around $200. Therefore, approximately $30,000 of the $30,200 bill was pure phantom tax on fees the client never touched.
The injury to feelings allocation proved neutral. Taxing that £45,000 in Britain would have cost £20,250 more to HMRC while generating an identical credit. Ultimately, the tax-free characterisation moved money between two treasuries and left the client no better off, which is precisely the insight a UK-only adviser cannot provide on an employment tribunal settlement.
How TaxYork Can Help
We work alongside your employment solicitor before the agreement is signed, not afterwards. Furthermore, we model each proposed allocation on both sides simultaneously so you can see the combined cost of every drafting option. That modelling routinely changes how our clients negotiate an employment tribunal settlement.
Our team prepares the American filings that follow, including Form 1116 and the supporting sourcing analysis. Additionally, we handle US tax return preparation for Americans abroad and the FBAR and FATCA reporting triggered when a large settlement lands in a British account. Where past years remain outstanding, we resolve those too.
Conclusion
An employment tribunal settlement is never a single number for an American in Britain. Instead, it is four or five separate tax events, each with a different treatment in two systems that disagree fundamentally. Therefore, the drafting of the agreement matters more than the headline figure.
Three points deserve your attention above all. Firstly, injury to feelings escapes UK tax but never escapes US tax. Secondly, legal costs that Britain exempts become taxable phantom income in America with no deduction available. Thirdly, the credit position depends on the effective UK rate across the entire award rather than on any single slice.
Above all, involve a cross-border specialist before you sign. Once the agreement is executed, the allocation is fixed and the American consequences follow automatically. Consequently, the value of advice collapses the moment the ink dries.
Contact Us
Speak to us before you settle. Our specialists will model your proposed employment tribunal settlement across both systems and show you the true combined cost of each allocation. Additionally, we coordinate directly with your employment solicitor so nothing falls between the two jurisdictions.
Email hello@taxyork.com or call 020 3488 8606 to speak with a specialist today. Alternatively, book a consultation at a time that suits you. Further background on British termination rules is available from HM Revenue and Customs.
Disclaimer
This article provides general information on the taxation of an employment tribunal settlement for US citizens and green card holders resident in the United Kingdom. It reflects law and published rates as at 31 August 2026 and does not constitute tax, legal or financial advice. Tax outcomes depend entirely on individual circumstances, the precise wording of the settlement agreement and the year of receipt. You should obtain professional advice before acting on anything set out above. TaxYork accepts no liability for any action taken in reliance on this article.