US Tax Return Preparation for Expats: Covenant Payments

A payment for agreeing to a non-compete, non-solicit or non-dealing covenant on leaving a London employer is taxed in full by HMRC as employment income under section 225 ITEPA 2003, with no £30,000 exemption. On the US return it is ordinary income, and where the covenant is sourced decides whether the UK tax can be credited.

For a US citizen leaving a senior role in the City, the restrictive covenant payment is often the largest and least understood item in the exit package. It sits alongside garden leave salary, a payment in lieu of notice, a compensation payment for loss of office and, often, deferred bonus and share awards that continue or lapse. Each element is taxed differently in the UK, and the US return has to follow a different map again. This guide sets out how specialist US tax return preparation for expats handles covenant payments: the UK charge, US character and sourcing, the foreign tax credit, the foreign earned income exclusion question, the mismatch between tax years, and how to put right earlier years that were filed incorrectly or not at all.

What is a restrictive covenant payment?

A restrictive covenant is a promise by the departing employee to limit what they do after they leave. In financial services the common forms are:

• Non-compete: not to join a competitor, or to work in a defined line of business, for a set period, often six to twelve months for senior bankers and fund professionals.
• Non-solicitation: not to approach clients, counterparties or investors of the former employer.
• Non-dealing: not to do business with those clients even if they approach you.
• Non-poaching: not to recruit former colleagues or team members.
• Confidentiality and non-disparagement undertakings, and the waiver of employment claims that is standard in a UK settlement agreement.

Covenants are frequently written into the original employment contract with no separate price, and then "refreshed" or extended in the settlement agreement on exit with a specific sum attached. That separately priced sum, or a slice of a larger global payment that the documents attribute to the covenants, is the restrictive covenant payment. How much of the package is attributed to it, and in which document, is the single most important fact for both returns.

How does HMRC tax a restrictive covenant payment?

Section 225 ITEPA 2003 applies where an individual gives an undertaking in connection with a current, past or future office or employment, the undertaking restricts their conduct or activities, and a payment is made in respect of giving it or fulfilling it. HMRC's own guidance at EIM03601 sets out these conditions. When they are met, the payment is treated as earnings from the employment for the tax year in which it is paid. Three consequences follow for a departing executive:

• No £30,000 relief. The £30,000 threshold in sections 401 to 404 ITEPA applies only to payments not otherwise chargeable. A section 225 payment is chargeable as earnings, so every pound is taxed at the marginal rate, typically 45% for a senior London earner.
• PAYE and National Insurance. Because the payment is earnings, the employer operates PAYE and Class 1 National Insurance through payroll. For a high earner the employee charge above the upper earnings limit is 2%, and the employer bears its own secondary contributions.
• The waiver of claims can be caught. HMRC's position, described at EIM03605, is that an agreement not to pursue tribunal or court claims is itself an undertaking restricting conduct. In practice HMRC generally accepts that a nominal amount is attributed to the waiver in a genuine settlement, but a large sum labelled "consideration for the waiver and covenants" invites a section 225 charge on the whole of it.

Settlement agreements often allocate a token sum, sometimes a few hundred pounds, to covenants in order to keep the rest of the payment within the £30,000 rules. Where the covenants have genuine commercial value, particularly a long non-compete for a revenue-generating banker or portfolio manager, HMRC may look through a token allocation. That is a UK compliance question, but the allocation the parties chose also drives the US treatment, so the US preparer needs to read the settlement agreement itself, not just the P45.

Residence and the UK charge after departure

Executives who leave London are often non-UK resident by the time the covenant payment arrives, or they fall into the split-year treatment for the year of departure. Because section 225 treats the payment as earnings from the employment in the year it is paid, the question of whether and how much of it is taxable in the UK after departure depends on how it relates to UK duties, residence status for that tax year and the treaty position. Where the covenant relates wholly to a London role, HMRC will generally expect the payment to bear UK tax even when paid after the individual has moved. This matters for the US return because only a UK tax that is legally due is creditable; a voluntary overpayment is not.

Separating the components of a City exit package

The US return cannot simply mirror the UK P45 or P60 total. Each component has its own UK treatment, its own US character, and potentially a different US source. The table below is the working map we use when preparing the return.

Component	UK treatment (HMRC)	US treatment (IRS)	Typical US source
Restrictive covenant payment (s225)	Earnings in full, PAYE and Class 1 NIC, no £30,000 relief	Ordinary income; generally not wages for services performed	Where the restricted activity would have taken place; apportion if the covenant covers several countries
Garden leave salary	Normal earnings, PAYE and NIC	Wages; employee is still employed and paid for being available	Generally where the employee is located during garden leave (time basis)
Payment in lieu of notice / post-employment notice pay	Earnings in full since April 2018, PAYE and NIC	Wages or compensation linked to the employment	Generally follows the services it replaces, usually the UK role
Compensation for loss of office (balance)	First £30,000 exempt; excess taxed; employer Class 1A NIC on excess	Ordinary income; no US equivalent of the £30,000 exemption	Generally follows the prior services, usually UK
Statutory redundancy pay	Within the £30,000 exemption	Ordinary income	Prior services, usually UK
Deferred bonus and share awards vesting after exit	Earnings when paid or vested, apportioned to UK duties	Compensation, taxed on vesting or payment	Allocated over the vesting or service period, often multi-year

Two points are worth emphasising. First, the US has no counterpart to the £30,000 exemption, so a compensation payment that is partly tax-free in the UK is fully taxable on the Form 1040; there is less UK tax to credit against it. Second, where the UK taxes the covenant payment more heavily than the loss-of-office payment, the choice of allocation in the settlement agreement shifts UK tax from one US income source bucket to another. For more on the termination component itself, see our guide on the UK £30,000 termination exemption on a US return.

Is a covenant payment ordinary income on the US return?

Yes. For an individual, a payment received for agreeing not to compete is ordinary income, not capital gain, and US case law has treated it that way for decades. The more difficult questions are what kind of ordinary income it is and where it comes from, because those drive the foreign tax credit and the foreign earned income exclusion.

There are two competing characterisations, and the documents usually point one way or the other:

• Payment for refraining from activity. The covenant is a separate bargain: the individual gives up a valuable right to work for a competitor or deal with clients, and is paid for doing so. On this view the payment is not compensation for personal services actually performed.
• Disguised compensation for past services. Where the covenant is boilerplate, unenforceable in practice, or the "covenant payment" in reality replaces forfeited bonus or represents deferred pay for the years worked, the IRS may treat it as compensation for past services, sourced and characterised like the services.

The preparer's job is to test the substance: whether the covenant was separately negotiated, whether it has a meaningful duration and geographic reach, whether the amount bears a sensible relationship to the income the individual forgoes, and whether it was paid regardless of the individual's performance. Those facts should be documented in the workpapers, because they support the position taken on the return.

Where is a restrictive covenant payment sourced for US tax?

US sourcing rules decide whether income is US source or foreign source, and for a US citizen that decides how much foreign tax credit can be used. For wages, the rule is simple: income is sourced where the services are performed, and multi-year compensation is generally apportioned on a time basis over the period to which it relates. A covenant payment is not a payment for services performed, so a different line of authority applies.

Long-standing US case law and IRS positions treat a payment for a covenant not to compete as sourced by reference to the place where the covenant restricts activity, in effect where the individual would otherwise have been free to work or compete. The reasoning is that the individual is giving up, and being paid for, a right exercisable in that territory. Applying that principle to a departing banker:

• A covenant that prevents the executive from working for a competitor in the United Kingdom or Europe generally produces foreign source income.
• A covenant that is global, or expressly covers the United States (for example a banker at a US bank's London branch barred from joining any competitor worldwide), may need to be apportioned between US and foreign source, on a reasonable basis such as the markets covered or the realistic alternative employment.
• If the payment is recharacterised as compensation for past services, it is sourced where those services were performed, which for a London-based career is usually foreign source, but can include US workdays for an executive who travelled heavily to New York.

These positions depend on facts and on the drafting of the covenant, and there is limited authority applying them to employees rather than business sellers. We flag the sourcing position as a judgement for verification on every file, and we document the apportionment method rather than defaulting to a single answer.

Why sourcing decides whether the credit works

The foreign tax credit on Form 1116 is limited to the US tax on foreign source income in the relevant category. If the covenant payment is foreign source, the UK tax on it, charged at up to 45% plus National Insurance, generally exceeds the US tax on the same income, and the credit eliminates the US liability with excess credits available to carry back one year or forward ten. If the payment is treated as US source, the limitation shrinks and the UK tax on that slice may not be creditable at all, producing genuine double tax.

Treaty re-sourcing for US citizens

The US-UK income tax treaty contains rules in its relief from double taxation article that, for a US citizen resident in the UK, can treat income that the UK is entitled to tax under the treaty as foreign source for the purposes of the US credit. Where the covenant payment would otherwise be US source but the UK has taxed it as earnings from a UK employment, the treaty re-sourcing route may rescue the credit. Treaty re-sourced income must be computed on a separate Form 1116 for that item, and a treaty-based return position is disclosed on Form 8833. Whether re-sourcing is available turns on the individual's residence for treaty purposes in the year of payment and on the treaty article that allocates the taxing right, so it is a position we verify case by case.

Which Form 1116 category?

Most executives' foreign income sits in the general category. A covenant payment connected with the employment is generally general category income rather than passive income, which allows the UK tax on it to be pooled with UK salary and bonus. Getting the category wrong can strand credits in the wrong basket, so the classification should be settled before the credit is computed.

Can the foreign earned income exclusion shelter a covenant payment?

The foreign earned income exclusion on Form 2555 applies only to earned income, meaning wages, salaries and other amounts received as compensation for personal services actually rendered, attributable to services performed while the individual has a foreign tax home and meets the bona fide residence or physical presence test. A payment for agreeing not to work is, on its natural reading, not compensation for services rendered, and the stronger view is that it is not eligible for the exclusion.

Even where part of an exit package is earned income, such as garden leave salary, notice pay or a bonus, the exclusion is attributed to the year in which the services were performed, not the year of receipt, and an amount received after the end of the tax year following the year of the services cannot be excluded. For a highly paid London executive the exclusion is usually the wrong tool anyway: UK tax exceeds US tax, so the foreign tax credit alone typically removes US liability and preserves excess credits. Claiming the exclusion can also block the credit on the excluded income and, once revoked, cannot be reclaimed for five years without IRS consent. The broader choice for senior executives is covered on our page for US-UK tax accountants for executives.

The UK tax year and the US calendar year

The UK tax year runs from 6 April to 5 April; the US tax year is the calendar year. An exit that straddles the two produces a predictable mismatch:

• A settlement signed in February with the covenant payment through March payroll falls in the UK tax year ending on the following 5 April, but in the US calendar year of payment, and the UK tax on it may not be finally settled until a later US year.
• Garden leave that runs from January to June is split across two UK tax years and sits entirely in one US year.
• UK tax is often not finally settled until the self assessment return is filed, by 31 January following the tax year, sometimes with a balancing payment or refund once split-year treatment and the section 225 charge are reconciled.

Most individuals claim foreign tax credits on the cash (paid) basis, which can leave the UK tax on a spring payment landing in a different US year from the income. An election to claim credits on the accrual basis aligns the UK tax with the income it relates to and, once made, applies to all later years. For an exit year it is usually worth modelling both, and where the UK liability changes after the US return is filed, an amended return or a foreign tax redetermination filing may be required. The mechanics of apportioning PAYE across two US years should be set out in the workpapers, using the UK payslips, P45, P60 and the self assessment computation.

A worked example

Consider a US citizen managing director at a London investment bank who resigns in March 2026 to join a US-based fund in New York later in the year. The settlement agreement provides:

• Three months' garden leave on full salary from March to May 2026.
• £400,000 for a nine-month non-compete and twelve-month non-solicitation covering the UK and European markets, paid in June 2026.
• £60,000 compensation for loss of office.

UK: garden leave salary is ordinary earnings. The £400,000 is earnings under section 225, taxed through PAYE in 2026/27 with Class 1 National Insurance. Of the £60,000, the first £30,000 is exempt and the remaining £30,000 taxed, with employer Class 1A on the excess. Split-year treatment may apply if the individual leaves the UK part-way through the tax year, which needs checking against the statutory residence test.

US 2026 return: all three amounts are gross income. Garden leave salary is foreign source wages (performed while in the UK). The £400,000 is ordinary income and, because the covenant restricts activity in the UK and Europe, a reasonable position is that it is foreign source general category income. The UK tax on it is creditable on Form 1116, and because the UK rate exceeds the US rate on that income, the result is generally no residual US tax on it, with excess credit carried forward. The £60,000 is fully taxable in the US, with the UK tax on the £30,000 taxed slice creditable. Once the individual becomes US resident, New York State and City residency rules add a further layer that must be addressed on the state return, including whether any of the exit income falls in the resident period.

If the same covenant had been global, a portion attributable to the US market could be US source, and the credit would then depend on treaty re-sourcing. That single drafting choice can change the US liability by a six-figure sum, which is why the document review comes before the return.

Information returns that often surface in the exit year

An exit year concentrates cash and accounts, and it is when many long-term London residents first discover gaps in their US reporting:

• FBAR (FinCEN Form 114) for UK bank, savings and brokerage accounts where the aggregate balance exceeded $10,000 at any time.
• Form 8938 for specified foreign financial assets above the thresholds for taxpayers living abroad, including UK pensions and ISAs in many cases.
• UK pensions and ISAs: ISA income and gains are taxable in the US, and some ISA holdings in UK funds raise PFIC reporting on Form 8621.
• Deferred awards and carried interest held through non-US vehicles, which may bring Form 5471, 8865 or 3520 questions depending on the structure.

Our FBAR penalty calculator gives a first indication of exposure where accounts have gone unreported.

Catching up omitted or incorrect years

Covenant payments are frequently mishandled in one of three ways: omitted from the US return because the individual assumed the UK tax "covered it", excluded under Form 2555 as if it were earned income, or reported as US source with the credit wrongly restricted. Each has a different fix.

• Return filed but wrong: an amended return on Form 1040-X within the normal three-year window, or ten years for a foreign tax credit refund claim, correcting source, category and exclusion. Where the correction increases credits, carryovers into later years must be recomputed.
• Returns not filed at all: a US citizen who has lived in London for years and never filed can generally regularise through the Streamlined Filing Compliance Procedures. The Foreign Offshore Procedures require the last three years of returns, six years of FBARs, and a certification that the failure was non-wilful, with no miscellaneous offshore penalty for those who meet the non-residency requirement.
• Returns filed but information returns missed: the delinquent FBAR or delinquent international information return procedures may apply where all income was reported.

An executive who moves to the United States in the exit year may no longer meet the non-residency requirement for the Foreign Offshore Procedures for later years, which makes it important to review eligibility before the move is complete. Our IRS streamlined filing team prepares the full catch-up package, including the non-wilful certification narrative.

What we need to prepare the return

• The original employment contract and any bonus, deferral or share plan rules.
• The settlement agreement, with its schedule of payments and the drafting of each covenant.
• Final payslips, P45, P60 and any P11D for the exit year.
• UK self assessment returns and computations, including the residence pages and any split-year claim.
• A workday calendar for the final years, showing days in the UK, the US and elsewhere.
• Details of UK bank, brokerage, pension and ISA accounts for FBAR and Form 8938.

Why a cross-border specialist matters here

A UK adviser will ensure the section 225 charge and the PAYE are right; a US preparer will report the income. The value is in reconciling the two: allocating the package so that each piece is sourced correctly, choosing the credit method that matches the UK tax to the income, and filing the treaty and information returns that support the position. Jungle Tax prepares US and UK returns for senior executives and financial services professionals with exactly these exit packages, working from the settlement documents rather than a single payroll figure.

If you have received, or are negotiating, a restrictive covenant payment on leaving a London role, or you suspect earlier returns treated an exit package incorrectly, contact our cross-border team for a confidential consultation. We will review the documents, confirm the UK and US treatment of each component, and prepare compliant returns for the current year and any years that need to be brought up to date.