A recent case has caused surprise when the First Tier Tax Tribunal decided for the first time that a payment to settle a discrimination claim case, calculated by reference to loss of earnings, was not taxable under section 62 of the Income Tax (Earnings and Pensions) Act 2003 ("ITEPA").

Compensation payments for termination due to discrimination that are calculated by reference to loss of earnings have previously been found to be taxable under section 401 of ITEPA (Walker v Adams [2003] STC 269 and Oti-Obihara v HMRC [2010] UKFTT 568 (TC)). (Section 401 ITEPA 2003 charges tax where payments or benefits are given in connection with termination of employment (for example, retirement, redundancy, dismissal, death, resignation and so on), or when the nature of the job or pay is changed, or when a periodical payment such as a pension payment payable on retirement is converted into a lump sum ("commutation") but in all cases only where no other section charges the payment or benefit to income tax.)

However, in this case the claim, which related to the alleged discrimination of the appellant, arose well before the redundancy so section 401 ITEPA was not in point.

As this decision may be appealed and is contrary to HM Revenue & Custom's long standing practice, employers should be wary about relying on the decision without further advice.

The facts

In Mr A (Appellant) v The Commissioners for Her Majesty's Revenue & Customs (Respondents)[2015] UKFTT 189 (TC) the appellant, Mr A, was a trader in a bank who claimed that over several years he was subject to discrimination on the grounds of race, which manifested itself in insufficient bonus payments and lack of salary increases. This was despite measurable good performance and various communications with management assuring him the position would be regularised.  He brought a number of grievances about his treatment between 2006 and 2007. 

In the latter part of 2007 the bank was bought out and Mr A and his colleagues were notified of imminent redundancies. At that point, he took legal advice.

On 19 March 2008, Mr A's solicitor served a questionnaire under section 65 of the Race Relations Act 1976 (although the statutory questionnaire process has now been abolished, it is still possible for prospective claimants to ask questions of their employers before bringing claims under the Equality Act 2010). On 26 March 2008 the bank informed him he was being made redundant because the fund on which he had worked had closed, and his job had disappeared. The bank offered him £1,650 in statutory redundancy pay and an ex-gratia payment of £48,898, with no mention of the questionnaire. A couple of days later the bank offered Mr A an additional lump sum of £600,000 if he signed a Compromise Agreement to settle his claims, which he duly did. The £600,000 lump sum was calculated with reference in particular to certain of the bonuses which allegedly were verbally promised but not paid.

HM Revenue & Customs ("HMRC") disputed that the payment was made in order to settle the potential discrimination claim and considered that the £600,000 was taxable within section 62 ITEPA as it was calculated with reference to unpaid earnings.

Mr A argued the payment was not earnings within section 62 ITEPA as it was not an emolument from employment, but instead an amount paid in settlement of any claim he may have against the bank, being the right not to be discriminated against on grounds of race (under the Race Relations Act 1976).

The parties agreed that section 401 ITEPA (the provision which brings payments made in connection with termination of employment into charge, with a statutory £30,000 exemption) was not in point because the payment related to the potential discrimination claim which arose well before and which was unconnected with the termination.

The Tribunal allowed the appeal, finding that the payment of the £600,000 was not taxable. The Tribunal was satisfied on the balance of probabilities that the payment was made to settle Mr A's potential claim for discrimination on grounds of race. The applicant did not need to prove discrimination or even different treatment (extending the decision in AB v HMRC [2011] UKFTT 685 (TC)), only that the likely reason the Bank made the payment was to settle the claim. Mr A was able to convince the Tribunal on the facts in light of the revised offer and requirement to sign a Compromise Agreement after the Bank had considered the discrimination questionnaire submitted to it. The Tribunal also found it was not relevant that there was no mention of the claim in the Compromise Agreement as it recognised the employer may not wish to include details of the alleged discrimination. In addition, the fact that there was no apportionment of the sum over different potential claims led to the Tribunal to the conclusion that the whole £600,000 was in settlement of the potential discrimination claim.

Once the Tribunal found it was likely the payment was made to settle the potential claim, they then decided it did not matter that the quantum of the settlement amount was calculated with reference to salary / bonuses which should have been paid – the nature of the payment did not change into earnings or an emolument from employment so it was not within section 62 ITEPA and was therefore not taxable.

What does this decision mean for employers?

While this case provides interesting analysis and appears to provide clear guidance on the tax treatment of a payment for a discrimination claim which arose before termination, taxpayers should be aware that as this is decision of the First Tier Tribunal it is not binding (even on itself). In addition, we still do not know whether the decision will be appealed by HMRC but we do know it is out of line with HMRC's long-standing practice, so it would be prudent at this stage to treat this decision with caution.  

Employers may be keen to make such a payment without deduction of tax so that the settlement amount could be reduced in line with the Gourley principle (as the quantum of the loss suffered by the individual would be an after tax amount).  

However, if an employer is minded to make such a payment without deduction of tax, they would be well advised to at least to agree with HMRC the treatment of settlements for potential discrimination claims before they are made.