In Oti-Obihara (appellant) v Commissioners for HM Revenue and Customs [2010] UKFTT 568 (TC), Edward Sadler (Tribunal Judge) in the First-tier Tribunal (Tax Chamber) held that compensation paid to a former employee, following allegations of discrimination, was subject to income tax only if it was compensation for financial loss arising from the termination of employment.

Broadly, the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) states that payments and other benefits received “as a consequence of, or otherwise in connection with – the termination of a person’s employment” will be subject to income tax (although the first £30,000 of such a payment is exempt from income tax).

In this case the former employer agreed to pay the appellant £500,000 “…as compensation for the termination of the [appellant’s] employment and in satisfaction of all claims in respect of the termination of the [appellant’s] employment… [the tribunal and grievance claims] and all and any claims of any kind whatsoever or however arising…”. The appellant had, among other things, lodged a claim in the employment tribunal claiming constructive dismissal, racial discrimination, victimisation and harassment.

HM Revenue & Customs (HMRC) and the appellant disagreed on how much of a settlement payment was received in connection with the termination of the appellant’s employment. Only this amount would be subject to income tax under ITEPA.

After hearing submissions from both parties, Judge Sadler decided that:

  • “the burden is on the appellant to prove, on the balance of probabilities, his case that a greater portion of the settlement payment was not an employment termination payment” and therefore not subject to income tax;
  • if the nexus between the discrimination and the termination of the employment is established a “compensation payment made on the occasion of the termination of employment for discrimination is taxable to the extent that it is compensation for financial loss suffered by reason of the termination of the employment — only to that extent is a payment received in connection with the termination of the employment”;
  • the settlement agreement between the appellant and the former employer did not state how much of the settlement payment was compensation for financial loss arising from the termination;
  • therefore the judge looked to the wider facts and held that it would be reasonable to assume that the compensation partly represented the appellant’s loss of earnings for a period of 18 months – that amount less the £30,000 deduction was the amount chargeable to income tax; and
  • this meant that £335,000 of the compensation payment was for non-financial loss and outside the scope of income tax.  

Comment

There was evidence that the former employer had given a generous settlement partly to protect its reputation and maintain privacy. It is therefore perhaps unfortunate for the former employer to nevertheless have the facts of the case given publicity in a later dispute between HMRC and the appellant.

The judge in this case said that the settlement agreement is the “primary document and evidence to determine what, at least as between the parties, the settlement payment was made for”. So perhaps parties should in future settlement agreements make it clear how much of the compensation is compensation for financial loss arising from the termination and how much is compensation for other matters. This might help avoid such disputes with HMRC.