The Coalition Government is currently consulting with stakeholders in relation to reforms regarding settlement arrangements between employers and their employees. In the meantime, we turn to one of the year’s most important cases regarding the taxation of termination payments made under a compromise agreement.

In Goldman v HMRC, an employee received a payment for damages under a compromise agreement after his employer breached his contract by failing to provide him with a payment in lieu of notice (PILON).  The First-tier Tribunal (Tax) subsequently held that the employee was liable for tax on the entire amount, even though the payment negotiated between the parties was less than the PILON itself.

Facts

After seven months service with “SpinVox”, Mr Goldman’s employment was terminated without notice following difficulties in his relationship with the company’s CEO. Clause 21.3 of his contract of employment provided that, if employment was terminated for reasons other than conduct or performance, he was entitled to a payment in lieu of notice equal to 12 months salary plus the health insurance premiums the company would have paid for his benefit during this period.  The company failed to pay the amount required under the contract, but following negotiations, a settlement was reached. Under the compromise agreement, Mr Goldman was paid more than £40,000 less than he was entitled to under clause 21.3. The settlement sum was paid in three tranches with the company making deductions for income tax at source.

The general principle under the Income Tax (Earnings and Pensions) Act 2003 is that the first £30,000 of a payment made as a consequence of the termination of employment, which is not otherwise chargeable, is exempt from income tax. However, a PILON made under an express contractual provision does not fall within this exemption.

When completing his tax self-assessment, Mr Goldman made a claim in respect of the income tax deducted from the settlement payment by the company on the basis that the payment was made as compensation for the termination of his employment. However, his claim was refused by HMRC on the basis that the payment was made under the PILON clause and was therefore taxable.

The Tribunal agreed with HMRC’s decision, holding that Mr Goldman’s claim was not in any realistic sense damages for the company’s breach of the employment contract and was therefore wholly taxable. In reaching its decision, the Tribunal focused on two facts. The first was that the negotiations between Mr Goldman and the company (disclosed to HMRC despite being without prejudice) were aimed at securing the payment of the sums due under the PILON clause. Secondly, the amount paid did not relate to the economic consequences of the breach of contract, as would be expected in any payment of damages.

Comment

The case highlights the tax implications of including a PILON clause in an employment contract, and the importance of applying the correct tax treatment before any payment is made to a departing employee. It is worth remembering that HMRC will usually first look to an employer to account for income tax which should have been deducted at source.  Whilst compromise agreements usually contain a tax indemnity in favour of the employer, enforcing this type of clause will prove challenging, and may ultimately be fruitless if the employee has already spent the money.