A tricky question regarding the tax treatment of different types of termination payments has been considered recently by the Upper Tribunal.

Employees who have suffered discrimination either during employment or on termination can seek compensation for loss of employment.  Many also seek compensation for injury to their feelings.  A recent tax Tribunal case has addressed how and when such payments may be taxable.

The default position is that payments related to the termination of employment will be taxable.  However, the first £30,000 of such a payment is generally free of income tax provided that it is not something to which the employee was contractually entitled.  Any excess compensation over £30,000 is taxable, unless it falls within a category of specific exemptions. 

One such category of exemption includes payments made in connection with the termination of employment by reason of the employee's death, disability or injury.  In an employment law case (not a tax case), the Court of Appeal decided that "injury" could also include injury to feelings, a type of compensation awarded to employees to compensate them for the hurt to their feelings due to the discrimination that they have endured.

The latest case from the Upper Tribunal (Tax) draws a distinction between discrimination during employment (in which case a payment for injury to feelings can potentially be made tax free) and discrimination in connection with the termination of employment (in which case a payment for injury to feelings will be taxable unless there is an identified medical condition in respect of which the payment is made).

Facts

Mr Moorthy was the Executive Director of Operations at Jacobs Engineering (UK) Ltd, earning £111,000 per year.  Mr Moorthy's employer decided they needed fewer senior managers and senior staff were told to apply for the remaining jobs.  Mr Moorthy failed to secure one of the new posts.

He was put on gardening leave for his entire notice period and was then paid his statutory redundancy pay of £10,640, without deductions for tax.  Mr Moorthy brought claims in an Employment Tribunal for unfair dismissal and alleged that he was selected for redundancy or dismissed because of his age. 

The parties engaged in a mediation process and Jacobs Engineering decided to settle Mr Moorthy's claims.  He received an ex-gratia sum of £200,000 and tax was deducted to the extent the payment exceeded £30,000.  When he submitted his tax return to HMRC, he explained that he considered that the entire sum should be tax free.

HMRC's approach

Not surprisingly, the tax authorities disagreed with Mr Moorthy's rather optimistic approach.  HMRC maintained that the compensation that exceeded £30,000 was taxable, although it indicated that they would allow him an additional £30,000 tax free sum on top by way of concession in order to reach agreement in the dispute.  Mr Moorthy challenged this decision saying that the award was compensation for injury to his feelings, but both the First Tier and on appeal, the Upper Tribunal, found against him. 

In brief, the Tribunals decided that since Mr Moorthy had not experienced any discrimination before being told that he was at risk of redundancy, his complaints related entirely to the circumstances of the termination of his employment.  As a result, only £30,000 of the payment could be made tax free, unless Mr Moorthy could show that he had suffered an "injury". 

The Upper Tribunal considered what "injury" meant and stated that they thought that it included personal injury, which could be the cause of a relevant injury or disability such as a psychiatric illness.  However, they had more trouble accepting that "injury" in this context included an injury to feelings.

The outcome was that all payments over £30,000 were taxable and Mr Moorthy also lost the benefit of the concession HMRC was prepared to make as this fell away when he chose to appeal.  In a further setback to Mr Moorthy the Upper Tribunal held that the £10,640 in redundancy pay he received counted as part of the £30,000 tax free threshold which resulted in a further increase in the amount of tax payable.

Practical points

Compensation for discrimination arising out of termination

This decision underlines the fact that labelling compensation for discrimination arising on termination as an award for "injury to feelings" does not act as a magic spell that makes the payment tax free.

In fact, a payment relating to an injury suffered due to a discriminatory termination will only be tax free where it is compensation for an employee who has suffered an actual physical or psychological injury, causing the termination.

Compensation for discrimination arising pre-termination

In contrast, this case clarifies that if Mr Moorthy had suffered age discrimination during his employment unconnected in any way with the termination of the employment, then the compensation that he received relating to the injury to his feelings, could potentially have been paid tax free.  The Upper Tribunal acknowledged that this was arguably an anomalous result but held that this was a consequence of termination payments being deemed to be earnings.

Plan payments carefully

To deal with this situation, parties should consider carefully:

  1. Whether the allegation of discrimination arises out of the termination of employment or something that happened during the course of the employment relationship; and
  2. What "injury" the employee has suffered – whether that's an injury to feelings or something more substantial, such as a disability or psychiatric illness.

Parties should consider apportioning payments between i) compensation arising out of discrimination during employment; and ii) compensation for discrimination arising in connection with the termination of employment.

Parties should also remember that the £30,000 tax free threshold is only available once in respect of an employment and if part of the threshold has already been utilised the employer may need to deduct further tax.