Settlement Agreements – to tax or not?

A v HMRC

The recent decision in A v HMRC [2015] UKFTT 189 illustrates the difficulty in determining the tax status of certain termination payments. The decision itself has been questioned since it does not reflect HMRC practice and is only a first tier tribunal decision. However, it remains a useful case to illustrate how a large payoff which takes into account an underpayment of bonus could still be treated as a payment to settle a discrimination complaint and therefore not be taxable as income under section 62 Income Tax (Earnings and Pensions) Act 2003 (ITEPA).

How termination payments are taxed

Generally, payments on termination of employment will fall into one of the following categories for tax purposes:

  1. Employment income - Section 62 and section 6(1) Income Tax (Earnings and Pensions) Act 2003 (ITEPA). Payments that relate to the period of employment up to the termination date are treated as earnings and therefore taxable in full as employment income See for example the recent case of Hill v HMRC
  2. In connection with termination - Section 401 ITEPA. This section applies to payments and benefits that are received directly or indirectly in connection with the termination of employment; the change in someone’s duties; or a change in earnings from a person’s employment. Such a payment may be made tax free up to £30,000 and any sum over that amount is taxed as employment income. Section 401(3) provides that the £30,000 exemption does not apply if the payment is otherwise chargeable to income tax.
  3. Redundancy payments - Section 309 ITEPA. This section provides for a limited exemption for statutory redundancy payments: no liability to income tax will arise by virtue of a redundancy payment and they will be taxable under section 401 (i.e. the £30,000 exemption will apply). This will include non-statutory redundancy payments that are genuinely made to compensate for loss of employment through redundancy.
  4. Discrimination compensation - Case law has indicated that where part of the compensation for discrimination relates to financial loss, this will generally be taxable under section 401 (above). However, if the payment compensates for injury to feelings and the discrimination is not linked to the termination of employment, it may be possible to pay the sum free of tax (see Walker v Adams (Inspector of Taxes) [2003] STC (SCD) 269 and HMRC Employment Income Manual: EIM 12965). See: http://www.hmrc.gov.uk/manuals/eimanual/eim12965.htm

The position of the HMRC is that: ‘Any part of the settlement that can reasonably be attributed to discrimination occurring before the termination should be accepted as not being employment income as it is not “connected” with the termination. However, where the compensation relates only to the consequences of the termination itself, no apportionment will be appropriate. For example, if the compensation is for loss of future earnings (after termination) it is all connected with the termination and Section 401 ITEPA 2003 applies even though the discrimination brought about the termination. If, by contrast, the compensation is for injury to feelings and there was discrimination before termination, then any part of that compensation that is not connected with the termination will not be within Section 401 ITEPA 2003’. HMRC recommends that the facts be analysed with care and part apportioned, if necessary, on a just and equitable basis.

Proposals for Reform

On 24 July 2015 HM Treasury published a Consultation on the simplification of the tax and national insurance treatment of termination payments – see more under What does the Future Hold? below

A v HMRC - £600 000 could be paid tax free

In A v HMRC, Mr A was the managing director of the Emerging Markets group at an unnamed Bank. Under the terms of his bonus scheme, he was eligible for a bonus based on the extent to which he achieved his personal sales and business development goals. Mr A was exceptionally successful yet for several years the bonuses paid to him were well below his expectations. When he challenged the payments, he was assured each time that the position would be rectified the following year. The Bank’s Chairman personally decided the bonuses. Mr A increasingly felt side-lined and treated less favourably. He alleged he was repeatedly being ‘fobbed off’ and noticed that his credit lines were being unfairly reduced. Comments were made to him that made him feel that he was being looked down upon in a way which referenced his ethnicity or nationality. He complained about these. Some time thereafter the Bank was bought out and he was made redundant.

Mr A brought a grievance with regard to his selection for redundancy and his unfair treatment by the Bank in relation to pay and bonuses. He stated that he considered the Bank to be in breach of contract that it had subjected him to unlawful discrimination on grounds of his racial or ethnic origin. Following negotiation, a compromise agreement was offered by the Bank which included the sums of £1,650 for statutory redundancy, £48,898 ex-gratia redundancy payment and the sum of £600,000.  The agreement contained the standard catch-all provisions in relation to the claims that he might bring, most of which had not been raised at all.

So, the issue in this case was: was the £600,000 chargeable to tax on earnings from employment because it was designed to make good the shortfalls in salary and bonus, as HMRC alleged, or was it compensation for Mr A’s threatened race discrimination claim? Section 62 ITEPA sets out what is regarded as ‘earnings’, which includes any salary, wages or fee; any gratuity, profit or incidental benefit; anything else that constitutes an emolument of employment. Mr A argued of course that the sum related only to his claim for discriminatory treatment and was therefore not to be taxed under sections 62 or 401. Before the tribunal, the only issue was whether the payment was taxable as earnings under section 62 as HMRC did not make any argument that the payment was in any way ‘in connection with’ Mr A’s termination of employment so as to fall within section 401.

The first tier tax tribunal noted that where damages are calculated by reference to underpaid earnings, while the discrimination may have manifested itself through the way in which the employee was remunerated, the damages arose not because the employee was under-remunerated but because the under-payment itself was discriminatory. In such circumstances, an award could not be a reward for services. Crucially, the tribunal ruled that Mr A did not need to prove that discrimination actually took place, only that the money was paid in respect of the discrimination claim. Indeed, it considered that even if the employer made the payment because he thought the employee had a good claim, whereas in fact it was not a good claim, this should not make a difference. HMRC’s approach of requiring Mr A to show proof that he was treated differently because of his race asked too much.

The enquiry into why a payment is made may reveal that there are multiple reasons. In this case, the compromise agreement was in standard terms listing all conceivable claims, many of which were irrelevant. It was therefore of limited use to determine why the sum was paid. The tribunal had to rely on Mr A’s evidence and other documentary evidence (the Bank called no witnesses). On evaluation of the evidence, it appeared to the tribunal that the payment was made in relation to the threat of a race discrimination claim. It was not necessary to apportion any component of the payment to the discrimination complaint and other components to other possible reasons unrelated to the merits of the dispute (e.g. ‘nuisance’ value, financial costs of litigation).

What does the future hold?

This case of A v HMRC should be viewed as helpful to employees but it does turn very much on its facts and is only a first tier tribunal decision. Mr A had raised complaints about discrimination relating to his bonus underpayments before the redundancy situation arose at work, which led to his termination. He received separate contractual and statutory payments for the redundancy. For this reason, the additional £600,000 payment was considered not as a non-contractual payment made as a result of the termination of employment and redundancy under sections 401-404 ITEPA (a point conceded by HMRC) but as a payment for discrimination. The tribunal’s approach of looking at the facts rather than at the specifics of the compromise agreement is helpful to employees since an employer who signs an agreement is unlikely to concede that discrimination took place.

Whilst helpful to employees, this decision is likely to be problematic for employers. The issue is what the real reason for the payment is: is it for the alleged discrimination or is it to reimburse for, say, an underpaid bonus? Each case will be different. In Walker (above) a compensation payment which was paid in relation to a discriminatory termination was found to be taxable under section 401 since it related to loss of earnings. In such a confusing situation, an employer may wish to obtain advance clearance from HMRC, require an indemnity from the employee for any underpaid tax or simply tax in full and tell the employee to make an application to HMRC for reimbursement of overpaid tax.  

HMRC Consultation

The government has for some time expressed concern about the complexity of the current tax system. It asked the Office of Tax Simplification (a body created by it to provide independent advice on simplifying the tax system) to review the law on termination payments. This led to a consultation published on 24 July 2015 to address the difficulties that the OTS report identifies.

In brief, the government proposes that there should be a new exemption which increases proportionately (up to a maximum amount) with the number of years service the employee has completed and which is available after the employee has completed two years’ service. The government is considering only providing tax and NICs relief where the termination payment has been made in connection with a redundancy (including voluntary redundancy) as defined in section 139 Employment Rights Act 1996. The government would put in place anti-avoidance provisions. The government intends to retain the exemption for injury or disability and seeks stakeholders’ views on whether any other exemptions should be retained. If the government proceeds with its approach of limiting the exemption to termination payments made in respect of redundancy then two new exemptions would be introduced: for payments made in connection with wrongful or unfair dismissal or compensatory payments made in cases of discrimination.

Clearly, if the proposals are introduced, this will be a major change to the system of taxing termination payments.