This is the first in a series of briefings on termination payments, focusing on the tax treatment of payments made in respect of injury to feelings paid in connection with termination of employment.
Moorthy v HMRC: where are we now?
The correct tax treatment of payments made in respect of injury to feelings paid in connection with termination of employment has for some time been uncertain as a result of conflicting case law. The recent Upper Tribunal decision in Moorthy v HMRC means that in most cases, HMRC will now seek to tax such payments.
Moorthy was a redundancy case where the taxpayer claimed that he had been unfairly selected for redundancy on the grounds of his age. He alleged age discrimination and unfair dismissal. He entered into a compromise agreement and claimed that the payment made by his employer was tax free as it was paid to compensate him for injury to feelings.
Payments made on termination of employment which are not otherwise taxable either as earnings or under any other section of the employment income tax code, fall into section 401 Income Tax (Earnings & Pensions) Act 2003 (Section 401). Section 401 brings within the charge to income tax any payment or benefit received “directly or indirectly in consideration of or in consequence of, or otherwise in connection with, a termination of employment”. This is subject to a series of exemptions, including for the first £30,000 of the termination payment and a further exemption (unlimited in amount) in Section 406 for payments or benefits made “on account of injury to, or disability of, an employee”. It was this further unlimited exemption which the taxpayer in Moorthy relied on, and which the Upper Tribunal rejected.
Timing of the payment: is it connected with termination of employment?
Section 401 only applies to payments which are made in connection with the termination of employment (or a change in duties). Payments for discrimination which are not connected with a termination of employment should not normally be taxable: they are not within section 401 and are not “earnings”. This applies whether the payment is to compensate for financial loss arising out of the discrimination or for injury to feelings.
Where the payment is made in connection with a termination of employment, Section 401 must be considered. It is in relation to such payments that the Tribunal in the Moorthy case rejected the approach in previous cases and held that a payment for injury to feelings is taxable.
The decision in the Moorthy case
The Tribunal in the Moorthy case decided two key points:
- That damages for injury to feelings for discrimination paid in connection with termination of employment are in principle taxable under Section 401 whether they relate to financial loss or injury to feelings, because the discrimination and the payment are both connected with the termination. In an earlier case, a lower Tribunal had distinguished between payments made on termination for financial loss (taxable) and payment for injury to feelings for discrimination (not taxable), on the basis that the latter was not compensation for termination but was compensation for the earlier discrimination. The Tribunal in the Moorthy case criticised this approach on the basis that this distinction was irrelevant and the correct question was whether there was a connection between the payment and the termination of employment; and
- That damages for injury do not fall within the exemption in Section 406 unless they amount to a medical condition which prevents the employment being carried on. The exemption will not normally therefore apply to damages for “injury to feelings”. Previous cases in the employment tribunals had not limited the exemption to injury causing a medical condition preventing the employment being carried on.
Where are we now?
The key question is whether the payment is connected to termination of employment:
- If there is no termination of the employment, Section 401 cannot apply. The only question then is whether the payment is “earnings”. It seems reasonably clear that damages for discrimination are not earnings and therefore not taxable. Other payments for injury to feelings should be similarly treated. The Moorthy case has not changed the position here.
- If the termination of employment itself constitutes the discrimination, as in the Moorthy case, then all payments are connected with the termination of employment and fall into the Section 401 code. FollowingMoorthy (which HMRC is likely to apply in all cases now unless and until it is successfully appealed) payments for injury to feelings will be taxable in the same way as a payment to compensate for financial loss.
- The position is now less clear if the discrimination occurred before termination of employment but leads to it, for example, where the employee claims constructive dismissal because of discriminatory treatment. HMRC’s guidance currently states that in the case of compensation for injury to feelings, if the discrimination occurred before the termination of employment, this is not taxable. In light of Moorthy, HMRC may very well now argue that the payment is connected with termination of employment in these circumstances and seek to tax the whole payment. Employers will therefore need to consider the position carefully.
Employers can no longer rely on the “injury to feelings” exemption in Section 406 unless that injury amounts to a medical condition which results in termination of employment.