In a recent case the First-tier Tribunal (Tax) confirmed that a compensation payment that was made to an employee on the termination of their employment was taxable, notwithstanding that the payment related to discrimination and injury to feelings. The Tribunal rejected a suggestion, based on previous cases, that termination payments designed to compensate for non-financial loss are exempt from income tax. 

Background facts

The case concerned an employee who had been dismissed by reason of redundancy.  The employee brought an employment tribunal claim alleging his dismissal was unfair and age discriminatory.  As a result of mediation, a compromise agreement was entered into and the employee received an ex gratia sum of £200,000 by way of compensation for loss of office and employment. 

The Tax Tribunal’s decision

The Tax Tribunal ruled that the £200,000 payment was taxable in full under section 401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA), subject to the application of the usual £30,000 allowance that applies to termination payments. In reaching this decision, the Tribunal refused to follow the decision in the earlier case of Oti-Obihara v HMRC [2010] UKFTT 568 (TC), where it had been suggested that only payments relating to financial loss would be taxable under section 401 ITEPA, with any other discrimination payments, such as payments relating to injury to feelings or to protect an employer’s reputation, escaping charge. 

The key to the Tribunal’s decision is the widely drafted wording in section 401, which applies to payments and benefits that are made “directly or indirectly in consideration or in consequence of, or otherwise in connection with” the termination of an employee’s employment.  If a payment is connected with termination it will fall within section 401 ITEPA even if it is also designed to compensate the employee for redundancy or financial or non-financial loss arising out of an alleged breach of his or her rights. In contrast, if a compensation payment is made to an employee for discrimination, injury to feelings or to protect the employee’s reputation and which is not “directly or indirectly in consideration or in consequence of, or otherwise in connection with” a termination, then this payment will not normally be taxable.

Comment

The decision emphasis that where the alleged discrimination is the act of termination itself, any associated payment made to an employee will, almost inevitably, be regarded as being connected to the termination and be charged to income tax in accordance with section 401 ITEPA. 

When negotiating the terms of a settlement agreement which provides for payment to be  made on or after the termination of an employee’s employment to compensate for discrimination, it is, therefore, crucial to consider whether the alleged discrimination is connected with the act of termination itself or whether the payment is in fact compensating for alleged discrimination suffered by the employee during the course of employment prior to any contemplation of termination of employment.  Of course, there will be grey areas between these two extremes and employers should consider taking advice before concluding any settlement. 

In respect of compensation sought from or awarded by a Tribunal, similar considerations apply, in that it is important to be able to identify what the compensation is intended to compensate for.  In light of this decision we can expect claimants to seek higher awards from Tribunals for injured feelings, relying on the well established legal principle that compensation should be ‘grossed-up’ so that the net amount received by the claimant (after tax) properly compensates them for their actual loss (known as the ‘Gourley principle’).  Although many awards will fall below the £30,000 threshold, this will not always be the case.

Finally, in some cases, where the impact of discrimination is so severe as to cause a mental impairment, such as depression, it may be possible to rely on the exemption from tax for payments on account of injury to, or disability of, an employee in s406 ITEPA.  In order to qualify for the exemption, however, an individual would need to have a medically recognised condition (supported by appropriate medical evidence, such as a doctor’s report); the Tribunal in Moorthy made it clear that mere injured feelings would not be an ‘injury’ for the purposes of section 406, putting paid to a suggestion to the contrary by the Employment Appeal Tribunal in the case of Orthet Ltd v Vince-Cain [2004] IRLR 857. Furthermore, case-law suggests that the condition must impair the employee’s ability to perform the duties of the employment.  Given the potential difficulty involved in satisfying these requirements we would usually recommend getting advance clearance from HMRC before seeking to rely on this exemption.

Moorthy v HMRC [2014] UKFTT 834 (TC)