A recent decision of the Upper Tribunal (Tax and Chancery Chamber) is very relevant to all employers in settling discrimination claims. It considers the tax treatment of injury to feelings payments; in unlawful discrimination claims these awards are made. Previously the Employment Appeal Tribunal has ruled that such payments be paid tax free under s.406 of the Income Tax (Earnings and Pensions) Act 2003. S.406 contains exempts from income tax payments made 'on account of injury to' employees.

However, in Moorthy -v- Commissioners for HM Revenue and Customs, the Upper Tribunal determined that  payments to compensate for injury to feelings for discrimination do not fall within the S.406 exemption; accordingly they are taxable.

Mr Moorthy was made redundant and claimed that his dismissal was both an unfair dismissal and a matter of age discrimination. These claims were subsequently settled under a compromise agreement (as they were then called) under which he received an ex-gratia payment of £200,000 as 'compensation for loss of office and employment'. His employer treated it as a termination payment under S401 of the Income Tax (Earnings and Pensions) Act 2003, paying the first £30,000 tax free and taxing the balance at basic rate. 

However, when Mr Moorthy completed his tax return he represented the whole payment as tax free being a settlement of a discrimination claim to compensate him for injury to feelings.  This was rejected by HMRC, who determined that in the circumstances it was a termination payment under S.401; however, as a concession it offered a further £30,000 tax free as damages for injury to feelings for age discrimination. 

Mr Moorthy appealed to the First Tier Tribunal, arguing that as the ex-gratia payment represented injury to feelings it was taken out of S.401 by S.406(b) ITEPA, which exempts a payment made on account of injury to or disability of an employee or in connection with termination of employment by the death of an employee. The First Tier Tribunal rejected the appeal, determining that the whole of the payment arose in connection with the termination of his employment, such that it fell within S.401. In doing so it held that HMRC had been wrong to offer the concession. 

Mr Moorthy appealed to the Upper Tribunal, which upheld the First Tier Tribunal’s decision.

The Upper Tribunal also considered whether injury to feelings fell within the scope of S.406 to qualify for the exemption, finding that they did not. The Upper Tribunal said that S.406(b) cannot be read as exempting all payments made by an employer in respect of injury to an employee;  the “injury” must be something which has led to the termination of employment or to a change in duties or level of earnings. Injury to feelings falls outside the scope of it. 

The practical implications of this for both employer and employees are significant as it appears to remove (subject to appeal) the more modest approach that is often suggested.