A damages payment for the loss of earnings in the course of employment due to racial discrimination has been held by a recent Tax Tribunal to be tax-free.

Background

The tax treatment of termination and related payments to exiting employees is a complicated area. Moreover, reviews as part of HMRC PAYE audits are relatively common and incorrect characterisations are expensive.

Broadly, payments may be taxed as normal employment income or termination payments but, if not caught by these two charging provision, can be completely tax-free.

  • Normal employment income would include contractual entitlements, bonuses and payments which an employer is entitled to make on termination of employment through contractual provisions (so-called contractual PILONs).  These are subject to income tax and NICs in full.
  • If, and only if, not taxable under the normal employment income head, other payments on termination – for example, genuinely ex gratia amounts or damages – normally fall to be taxed as termination payments. This is a much more tax-favourable category as these payments are (currently) entirely free from NICs and in most cases benefit from at least a £30,000 exemption.  This means that many smaller payments escape tax altogether.
  • However, if payments are not caught as employment income or as a termination payment, then, because there is no relevant taxing provision, they can be completely tax-free.

Facts

The employee worked at a London financial institution and claimed that he had received lower remuneration than he should have received by reference to the profits earned by his own trading and relative to his peers, and that the reason for this was racial discrimination. He had made his complaints over a number of years. This culminated in him raising formal grievances at a time when he was being considered for redundancy. He was made redundant. He was initially offered just statutory redundancy pay and an ex gratia payment of c. £50,000, but within a few days was offered a further sum of £600,000 to settle all claims.

Tax treatment

In due course HMRC asked the financial institution questions about the £600,000 payment, and the disputed tax treatment ended up being considered by the Tax Tribunal.

It was accepted in this case that the payment could not be a termination payment because, although made on termination of employment, it related to matters considerably prior to termination. The case therefore turned on whether the payments could be treated as normal employment income or whether they were altogether tax-free.

The tribunal held that the payments were for not contractual entitlements (on the basis of promises made, for example, for which there was some evidence, and which is what HMRC primarily alleged). Instead they were for breach of the right not to suffer racial discrimination.

HMRC also argued that even if the payments were for racial discrimination and not contractual, they should be taxed as normal employment income as they were calculated by reference to lost earnings which would have been taxable in full if they had been paid in the proper course. However, the tribunal pointed out that the mere fact that damages are calculated by reference to what could have been paid does not make them earnings or a reward in an employment context, which is what is needed to make the payments employment income for tax purposes.

Conclusion

As always, much turns on the evidence presented, and here there was oral evidence from the employee but no direct evidence from the employer.

Employees may therefore put more pressure on employers to apportion amounts to discrimination claims in general. Accepting this characterisation can be unpalatable for employers, however, even though in this case there was no direct acceptance by the employer that there had been racial discrimination (which was one of the reasons HMRC used to argue that the payments must have been for contractual employment claims for loss of earnings instead). The potential publicity and precedent (eg in the public sector) which could result might be difficult for an employer to accept.  In addition, because this is just a first-instance judgement caution may still mean that employers may wish to get clearance from HMRC on the tax treatment in large claims or obtain an indemnity from an employee in appropriate cases. In this area, and with awards for discrimination potentially sizeable, the stakes are high. The difference between taxable and tax-free can easily be a six-figure dispute with HMRC. 

Note too that not all payments for discrimination are tax-free. Where the discrimination itself is the termination of the employment or what leads to the termination of the employment, payments for lost earnings etc. would be treated as sufficiently connected to termination to be taxable as termination payments and it would only be any damages awarded for distress that would not be taxable. In this tribunal case, redundancy was what triggered the end of the employment and it was only then that the employee mounted legal claims for what he had been arguing for some time. Those payments could therefore not form part of the termination proceedings. 

As a concluding remark, quite whether there is any overriding policy justification for the way that tax law has developed in this area into extreme complexity is of course one reason why the Office of Tax Simplification has recommended that the law is brought together and considerably simplified – but, as this case shows, in some instances this would be at the expense of some extremely tax-favourable results for employees and employers alike.

For a link to the relevant Tax Tribunal case, click here.   

For a link to the office of Tax Simplification proposals on termination payments, click here.