In Moorthy v Commissioners for HMRC, the taxpayer was selected for redundancy and brought unfair dismissal and age discrimination claims, which were settled for £200,000.  He tried to argue, relying on previous decisions, that because the payment was made to settle the discrimination claim, it should be paid tax free.  HMRC allowed only the unused balance (after deducting an earlier statutory redundancy payment) of the standard £30,000 tax free element and assessed the rest of the payment as subject to tax. (HMRC initially offered an extra tax-free amount as a concession but the Tax Tribunal said this was invalid.)  The taxpayer appealed.

The Tax Tribunal found that the payment was clearly made "directly or indirectly in consideration or in consequence of, or otherwise in connection with" the termination of the claimant's employment.  He had not alleged that there had been any discrimination prior to his selection for redundancy.  There was no reliable authority to back up the claim that discrimination payments are always non-taxable.  The Upper Tribunal has now confirmed this analysis. 

The provision taxing termination payments (section 401) is very widely drawn and if a payment falls within section 401 because it is in connection with the termination then it is taxable regardless of the reason for the payment – no distinction should be drawn between compensation for financial loss and payments for injury to feelings.

As to whether injury to feelings payments are taken outside the tax charge by the exemption (in section 406) for payments made "on account of injury to, or disability of, an employee", the Upper Tribunal was clear that injury to feelings payments are not the sort of "injury" envisaged by section 406 – what it requires is a medical condition that results in the termination of employment or a change in employment duties or earnings.

On the basis of this decision, employers should be deducting tax on the full amount of any compensation payment connected with the termination of employment (less any available part of the £30,000 tax free sum). If tax has not been correctly paid in the past, then assuming no clearance was obtained, HMRC can in theory recover unpaid tax (going back four years) from the employer. 

There is still some scope to argue that where compensation is paid to reflect discrimination that was not connected to the termination of employment, this should not be taxable, provided there is clear evidence separating the discrimination from the ultimate dismissal.  In A v HMRC last year, the Tax Tribunal found that a payment made to compromise a potential discrimination claim, calculated by reference to allegedly underpaid bonuses, should not be taxed as earnings.