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Moorthy v The Commissioners for Her Majesty’s Revenue and Customs [2016] UKUT 13 TCC considers the extent to which a payment made by an employer to settle a claim for unfair dismissal and age discrimination should be treated as employment income by virtue of sections 401 and 403 of the Income Tax (Earnings and Pensions) Act 2003 and therefore be chargeable to income tax.

Facts

In March 2010, Mr Moorthy was made redundant by his employer, Jacobs Engineering (UK) Limited (Jacobs). Mr Moorthy alleged that the circumstances of his dismissal amounted to unfair dismissal and age discrimination so he brought a claim in the employment tribunal. Following mediation, Mr Moorthy and Jacobs entered into a compromise agreement under which Jacobs agreed to pay Mr Moorthy “an ex gratia sum of £200,000 by way of compensation for loss of office and employment”.

Mr Moorthy was paid the settlement amount by Jacobs in two tranches in the 2010/11 tax year. Jacobs treated the first £30,000 of the settlement amount as exempt from tax by virtue of section 403 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) and deducted income tax at the basic rate from the balance. Mr Moorthy completed his self-assessment tax return for 2010/11 on the basis that the full settlement amount was tax free. HMRC did not agree and, in August 2013, issued a closure notice amending Mr Moorthy's self-assessment return for 2010/11 to include an additional £140,023 as taxable income. HMRC did, however, make a concession to treat a further £30,000 as damages for injury to feelings arising from age discrimination and so not taxable. 

A brief reminder: the charge to tax

Sections 401 and 403 ITEPA provide that payments or benefits received in consequence of, or otherwise in connection with, the termination of a person’s employment are taxable, save for the first £30,000 of such a payment, which is tax free.

HMRC advises that compensation payments that are for discrimination that occurred prior to termination (and are unrelated to it) are wholly exempt from tax. However, if the compensation payment is for discrimination connected with the termination, then it will be taxable as per sections 401 and 403 ITEPA (ie up to £30,000 tax free, the rest taxable).

The first appeal 

Mr Moorthy appealed to the First-tier Tax Tribunal (FTT) against the amendment to his return. The FTT held that the whole settlement amount fell within section 401 ITEPA and was chargeable to tax subject to the £30,000 exemption. However, the statutory redundancy payment paid in 2009/10 had reduced the exemption allowed to £19,360. Further, the FTT stated that it had no jurisdiction to allow a further relief of £30,000, treated by HMRC as a concession, as damages for age discrimination and outside the charge to income tax.

Mr Moorthy subsequently appealed against this decision. His appeal raised three main issues:

  • whether the entirety of the settlement payment fell within section 401 ITEPA;
  • whether “injury” in section 406 ITEPA included injury to feelings; and
  • the effect of the concession made by HMRC that £30,000 of the settlement payment should be treated as damages.

The appeal to the Upper Tax Tribunal

The Upper Tax Tribunal (UTT) dismissed Mr Moorthy's appeal. 

The UTT agreed with the FTT that the entirety of the £200,000 settlement payment fell within section 401 as a payment made in connection with the termination of Mr Moorthy’s employment. This section applies to all payments received directly or indirectly in consequence of the termination of employment, even where the termination was fair and lawful, and includes non-pecuniary awards such as damages for injury to feelings. Even if the amount paid might exceed the statutory maximum that could be awarded for unfair dismissal, that did not mean that the excess was unconnected with the termination of the employment. 

As for the exemption in section 406, the UTT could not accept that, insofar as the sum represented damages for injury to feelings, it was a payment on account of “injury”. The meaning of “injury” could not be read as exempting all payments made by an employer in respect of an injury to an employee; rather, it was intended to apply to injuries that led to the termination of employment or to a change in duties or level of earnings. In so holding, the UTT stated that the EAT was wrong to decide that injury to feelings was covered by section 406 ITEPA in Vince-Cain v Orthet Ltd [2004] UKEAT/0801/03 and Timothy James Consulting Ltd v Wilton [2015] UKEAT 0082/14. 

Further, the UTT held that HMRC had not been entitled to offer Mr Moorthy a concession that £30,000 of the settlement amount could be attributed to injury to feelings and so not liable to tax. Therefore Mr Moothy was liable to tax on the entire £200,000 save for the first £30,000 that was exempt. 

Comments

Although this decision does not constitute a change in the law, it is highly relevant to employees, employers and practitioners as it provides clarity and certainty in relation to the rules surrounding compensation payments relating to discrimination and when they will be taxable (when relating to termination) and when they will not (when relating to discrimination otherwise than in relation to termination, eg during employment).

It is arguable that this decision may affect employers' ability to settle existing discrimination claims. This is because a settlement sum being “tax free” has been a helpful negotiation tactic for employers to encourage settlement.

It is still possible, however, to pay tax free compensation where the discriminatory treatment is not termination-related. In more complicated situations, where discriminatory treatment happens both during employment and on termination, employers should appropriately apportion the compensation to reflect the discriminatory treatment during employment (which can be paid tax free) and termination-related discriminatory treatment (which is taxable, subject to the usual £30,000 exemption). 

In any event, to protect themselves, employers should ensure that their standard settlement agreements contain a tax indemnity clause, requiring the employee to reimburse to the employer any tax that becomes payable to HMRC.

The Government consulted on changes to the taxation of termination payments last year. The response is expected later this year and may substantially alter the way in which termination payments are taxed.

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