In this recent case, the Upper Tribunal (“UT”) provided guidance on the taxation of awards for "injury to feelings" paid in respect of the termination of employment.

Mr Moorthy had been made redundant and subsequently brought a claim against his employer on the basis that he had been dismissed unfairly due to age discrimination.  This claim was settled and Mr Moorthy received £200,000 in compensation.

The main issue for the UT was whether this £200,000 was taxable as a termination payment and, if so, whether it was exempt because it was paid in connection with injury to Mr Moorthy’s feelings.  HMRC had previously conceded that £30,000 of the settlement amount should be treated as non-taxable damages for age discrimination.  The UT also had to decide whether Mr Moorthy could rely on this concession.

Was the payment made as compensation for loss of employment?

The first question in relation to any termination payment is whether it is earnings from the employment on first principles.  The question can be summarised in different ways, but a good test is to ask whether it is "by way of reward for past, present or future service".  If it is then it is taxable under normal income tax principles as earnings from the employment (and the exceptions below do NOT apply to it).

Some termination payments and benefits are not by way of reward at all.  However, such payments and benefits are usually still brought into tax if they are received "directly or indirectly in consideration or in consequence of or otherwise in connection with the termination of a person’s employment".  Unlike the general earnings charge, this special tax charge has various exceptions.

The most well-known exception is the exemption for the first £30,000.

There is also an exception for payments in connection with the termination of employment by the death of the employee or on account of their injury or disability.

Mr Moorthy argued two things.

First he argued that the £200,000 compensation paid to him was not in connection with the termination of his employment in any case.

Second he argued that, even if it was, it was excepted from tax because it was a paid on account of injury to his feelings.  He claimed that the payment could not have been made on account of his redundancy because it was higher than the maximum amount he might have received on an unfair dismissal claim and represented damages for discrimination.

The UT found that the payment was made in connection with the termination of Mr Moorthy’s employment, in particular because Mr Moorthy had not been discriminated against before the termination of employment - the termination of employment itself was the discrimination.  This followed the decision in the First Tier Tribunal.

Was the compensation exempt from tax as an award for injury to feelings?

The UT then had to consider whether the payment was exempt from tax because it was paid to compensate Mr Moorthy for injury to his feelings.

The UT found that ”injury” in the context of the exception to tax on termination payments did not include injury to feelings.  In the context of the legislation, which also referred to disability and death, “injury” was taken to mean a medical condition.

Could Mr Moorthy rely on HMRC’s concession?

On closure of an enquiry into Mr Moorthy’s tax affairs, HMRC had offered to treat an additional £30,000 of the compensation as not taxable on the grounds that it was compensation for age discrimination.  Mr Moorthy argued that, even if the compensation was taxable under general legal principles, HMRC's concession created a “legitimate expectation” as to the treatment of the £30,000 in respect of which the offer had been made.  The UT found that Mr Moorthy could not have had such a legitimate expectation because HMRC had made the concession as a way of trying to reach agreement and Mr Moorthy did not accept the offer in any case.  The UT suggested that, had HMRC made a more formal ruling on the point, this may have given Mr Moorthy a legitimate expectation.  The UT also questioned whether HMRC had the jurisdiction to waive tax which was properly due, although they did not need to consider this point in detail.      

Comment

The decision in this case is not surprising in that the courts have consistently upheld the principle that where a payment is made as compensation for termination, it will be taxed as a termination payment, regardless of whether it was also intended to compensate for discrimination or injury to feelings as a result of the dismissal.  The UT admitted that there is arguably an "anomalous distinction" in that damages paid for discrimination in the course of employment are not taxable.

The UT’s comments on HMRC's concession are interesting and show that an offer from HMRC not to tax a particular payment cannot necessarily be relied upon where the correct legal position is that a payment is taxable.  However, the taxpayer may be able to take more comfort from a ruling from HMRC.  In circumstances where HMRC has made an offer to settle but the taxpayer is considering taking his case to the tribunal, it will be necessary to take in account the risk of losing the offer on the table as a result of the tribunal decision.