The Upper Tribunal has clarified that any compensation payment made in connection with termination of employment will be taxable as a termination payment under S.401 of the Income Tax (Earnings and Pensions) Act 2003, and that the exemption for payments by way of "injury" to an employee does not include a payment in respect of injury to feelings. In reaching its decision, the Upper Tribunal considered that previous EAT authority to the contrary had been wrongly decided.

Background

Under section 401 of the Income Tax (Earnings and Pensions) Act 2003 (S.401 ITEPA), any payments and / or benefits which are "received directly or indirectly in consideration or in consequence of, or otherwise in connection with the termination of a person's employment" is subject to income tax. Section 403 ITEPA (S.403) provides that the first GBP30,000 is exempt from income tax. 

ITEPA provides for other income tax exemptions for S.401 payments, including where the payment is made "in connection with the termination of employment by the death of an employee, or on account of injury to, or disability of, an employee" (S.406 ITEPA).  The EAT has previously held that the exemption in S.406 extends to compensatory payments for injury to feelings, (see Orthet Ltd v Vince-Cain [2004] and Timothy James Consulting Ltd v Wilton [2014]).

Moorthy v The Commissioners for Her Majesty’s Revenue and Customs

Mr Moorthy brought claims in the Employment Tribunal alleging that his dismissal for redundancy was unfair and discriminatory on the grounds of his age.  Following mediation, Mr Moorthy entered into a settlement agreement with his employer in which he was paid an ex-gratia payment of GBP200,000 by way of compensation for loss of office and employment.  The first GBP30,000 of that ex-gratia payment was paid tax free and the remaining GBP170,000 paid after deductions.

In his annual tax return, Mr Moorthy submitted that no deductions should have been made and asked for the tax to be repaid.  The HMRC decided against Mr Moorthy, holding that the ex-gratia payment was subject to tax under S.401 ITEPA.

Mr Moorthy appealed to the First-Tier Tribunal (FTT). The FTT considered that the ex-gratia payment was made in connection with the termination of his employment and was therefore taxable under S.401 ITEPA. Mr Moorthy appealed to the Upper Tribunal (UT).

Upper Tribunal Decision

S.401 ITEPA

The UT found that the ex-gratia payment fell within S.401 ITEPA and was therefore subject to tax.  It rejected Mr Moorthy's submission that a distinction should be made between pecuniary aspects of a payment, e.g. financial losses, (which were taxable) and non-pecuniary aspects, e.g. injury to feelings, (which were not taxable), following the FTT's decision in Oti-Obihara v HMRC.  The only question that should be asked is whether the payment is connected to the termination of employment.  In this case, Mr Moorthy's complaints of discrimination arose out of his dismissal for redundancy and there were no complaints of discrimination prior to his selection for redundancy / dismissal.  Therefore, the ex-gratia payment fell squarely within the scope of S.401 ITEPA.

S.406 ITEPA

The UT went on to consider whether the payment should nevertheless be excluded from taxation under S.406 ITEPA as a payment or benefit on account of an injury.  The EAT had previously held inOrthet and Timothy James Consulting that the reference to "injury" in S.406 ITEPA extends to injury to feelings and, further, that any injury to an employee would fall within S.406 ITEPA and be exempt from tax (even if the payment was made in connection with the termination of employment).

The UT considered that the EAT's decisions in Orthet and Timothy James had been wrongly decided.  The UT held that S.406 ITEPA is not a general exemption from tax for payments on account of an injury. Rather, its purpose is to make exceptions from tax for certain payments which would otherwise fall within the scope of S.401 ITEPA.

The UT also considered that the reference to "injury" in S.406 ITEPA should be interpreted narrowly and in the context of that section i.e. by reference to "death" and "disability", such that it only covered medical conditions leading to the termination of employment. It did not therefore extend to payments in respect of injury to feelings. 

Comment

The UT's decision is a clear reminder that a payment falls within the scope of S.401 ITEPA when it is "connected to" termination of employment and this will be interpreted widely. If however the payment is not connected to termination of employment, for example, if it is made to settle claims of discrimination arising during employment, the payment falls outside the scope of S.401 ITEPA and is not subject to taxation.  In a case where payments are being made to settle claims that cover both a period during employment and on termination, care should be taken to apportion the payments in the settlement agreement.

What is less certain from this decision is whether a payment for injury to feelings that is connected with the termination of employment falls within S.406 ITEPA so as to be exempt from taxation.  The UT clearly thought not, but their decision is inconsistent with previous EAT authority on the point.  It is hoped that the matter will be considered by the Court of Appeal to provide certainty on this point.  In the meantime however, it is likely that HMRC will choose to follow the UT's decision that a payment for injury to feelings is subject to tax.  Employers may therefore find themselves facing greater pressure from claimants to gross up any compensatory payments made on termination of employment to mitigate the effect of the deductions.

In a related development, the Government announced in its recent Budget that from April 2018 termination payments over GBP30,000 that are subject to income tax will be subject to employer National Insurance Contributions.  However, the whole termination payment will be exempt from employee NICs, (see our separate alert on the recent Budget announcements).