One of the first questions most employees ask when presented with a settlement agreement relating to the termination of their employment is whether the termination payment will be paid free of tax. The answer is not always straightforward. In a recent decision, the Upper Tribunal considered the tax treatment of a payment made by an employer to settle a claim for unfair dismissal and age discrimination following the termination of employment.

Background

The starting point for the taxation of payments made in connection with the termination of employment is that they are taxable under section 401 Income Tax (Earnings and Pensions) Act 2003 although under section 403 of the Act, the first £30,000 of a termination payment can be paid free of tax.

Under section 406 of the Act, an exception is made for termination payments which are made on account of injury to or disability of an employee. The Employment Appeal Tribunal concluded that this exception extended to payments made to reflect a potential award for injury to feelings where allegations of discrimination had been made.

Payments made to compensate an employee for discrimination can be paid tax free.

Facts

In the case of Moorthy v HMRC, an employee who had been made redundant by his employer and received a statutory redundancy payment brought proceedings for unfair dismissal and age discrimination in the employment tribunal. Following mediation with his ex-employer, his complaints were settled and a payment of £200,000 was made to him “by way of compensation for loss of office and employment.” 

The claimant sought confirmation from HMRC about the tax status of the payment he had received and argued that the payment should not be subject to tax as it had been paid primarily to settle his potential age discrimination claim rather than for the termination of his employment. HMRC carried out a formal investigation and concluded that the payment was taxable under section 401 of the Act, save for the first £30,000 which could be paid tax free. HMRC also offered a concession by way of settlement that a further £30,000 could be paid tax free. The claimant appealed this decision through formal review stage, to the First Tier and Upper Tribunals. At all levels of the appeal process the decision was the same.

Decision

The Tribunals made a distinction between compensation for discrimination which occurs during employment and discrimination which relates to the termination of employment. Once it is established that there is a connection between a payment and the termination of employment, the payment falls to be taxed under section 401, regardless of the reason for the payment.  In this case, the elements of discrimination on which the claimant relied in his tribunal claim all related to the termination of his employment, which meant that the payment had been made in connection with the termination of the claimant’s employment and so should be taxed under section 401 as a termination payment. 

Further, the Upper Tribunal concluded that the reference to injury in section 406 meant a medical condition which leads to the termination of employment and did not extend to cover injury to feelings suffered as a result of discrimination, so the payment in this case did not fall within the section 406 exception either.

Comment

This case demonstrates the complexity of the current system of taxation for termination payments and the need to ensure that where a termination payment includes an element of compensation for discrimination, that part of the payment which relates to pre-termination discrimination is clearly identified.

The tax treatment of termination payments is currently under review and a set of proposals to simplify the law in this area has been put out for consultation. Proposals include removing the distinction between different types of payment on termination, replacing the current £30,000 allowance with an exemption for redundancy at a rate rising in line with length of service, and introducing new exemptions for wrongful dismissal, unfair dismissal and discrimination. A response to the consultation is expected in the near future.

Moorthy v HMRC [2016] UKUT 13 TCC (14 January 2016)