The recent decision by the First-tier Tribunal in Reid v HMRC is a timely reminder for employers and employees of the importance of carefully analysing the tax status of all elements of a termination payment. 

In this case, Mr Reid was a director of a company who, shortly after joining the company, entered into an Enterprise Management Incentive (EMI) share option agreement with the company.  Under the terms of the agreement Mr Reid paid £30,000 to the company in return for the grant of the options.  It was understood by both parties that the £30,000 would be refunded if Mr Reid ceased to be employed by the company prior to exercising the options.

A few years later Mr Reid resigned and entered into a compromise agreement with the company. The compromise agreement stated that the company would pay Mr Reid the sum of £77,731 by way of compensation, less any income tax or national insurance that the employer was required by law to deduct (the "Termination Payment"). The compromise agreement contained no further detail regarding the Termination Payment other than to state that it included any statutory redundancy pay due to Mr Reid; no reference was made to the repayment of the £30,000 paid by Mr Reid for the EMI options. 

Mr Reid subsequently filed his self-assessment tax return, which he prepared on the basis that the £30,000 he paid for the EMI options was a refund due to him by the company and, as such, was not taxable.   HMRC issued an assessment to Mr Reid for the income tax due on the undeclared £30,000 and Mr Reid appealed to the First-tier Tribunal. 

In dismissing the appeal the Tribunal found that, while there was an understanding between the parties that the £30,000 would be refunded on termination, it was unable to find in Mr Reid's favour because the compromise agreement did not characterise any part of the Termination Payment as a refund and, as the compromise agreement contained an entire agreement clause, it superseded all previous agreements and understandings between the parties.  Therefore, in the Tribunal's opinion, the lack of any reference in the compromise agreement to the refund, combined with the entire agreement clause, resulted in the £30,000 becoming taxable when, if it had been paid on its own or identified separately in the compromise agreement, it may not have given rise to any tax liability.

There are elements of this decision that are unclear and it remains to be seen whether it will be appealed.  Nevertheless, the decision is an important reminder that employers and employees should seek advice in relation to the tax consequences of termination payments, even where the tax treatment appears straightforward, and compromise agreements should, where appropriate, contain the reasons why the employer is paying each element of a termination payment to the employee.