The Upper Tribunal has given some clarity on the question of the taxation of an injury to feelings compensation payment made in connection with termination of employment. Not a day to day issue for many employers – but one which when it does arise (and I’ve come across it on a number of occasions in my career) can be a huge sticking point as far as any settlement is concerned.
We all know (or think we know) the basics here. The first £30,000 of a (non-contractual) compensation payment made in connection with termination of employment is tax free (s 403 ITEPA 2003): the balance is normally taxable as a termination payment (s401) unless it falls within one of the specific exceptions set out in the legislation (s405 to 414A). One of the exceptions relates to payments made in connection with the termination of employment by the disability of or injury to an employee (s406). But there has been uncertainty in the case law to date over the extent to which ‘injury’ in this context includes injury to feelings, or whether (taken in the context of the rest of the section) it means a medical condition which has led to the termination of employment.
A 1995 case (Horner) confirmed that to fall within the exemption there must be ‘an identified medical condition that disables or prevents the employee from carrying out the duties of the employment’: in other words a ‘total or partial impairment of his ability to perform the duties of his employment’. In 2004, however, in the case of Orthet, the EAT concluded that compensation for injury to feelings could fall within the exemption for payments made ‘on account of injury to, or disability of, an employee’ in section 406 (remarking that such damages were analogous to awards for pain and suffering, disability etc in PI Cases) and noting in addition that ‘not a word was said’ in Vento about such awards having to be taxed. In a further case (Timothy James) in 2014, the EAT looked again at taxation of injury to feelings awards in discrimination claims and accepted that there were conflicting authorities. It decided that because the reference to ‘injury’ in section 406 was not accompanied by qualifying words along the lines of ‘in connection with termination of employment’, any injury to an employee could fall within the exemption. It concluded that the section 406 exemption included both physical injury and injury to feelings, following the line of reasoning in Orthet.
In the current case, Moorthy v HMRC, the claimant was dismissed by reason of redundancy in 2010. He subsequently claimed age discrimination and unfair dismissal in the employment tribunal (his claim solely related to his selection for redundancy and prior to this point he had not experienced any discrimination). A compromise agreement was concluded, under which he received an ex gratia sum of £200,000 by way of ‘compensation for loss of office and employment’. He argued that this payment should not be taxable, and, having investigated, HMRC concluded that the sum was taxable other than for the first £30,000 (together with a further £30,000 stated to be by way of ‘concession’ – this was subsequently disallowed by the tribunal). The claimant appealed first to the First-tier tribunal and subsequently to the Upper Tribunal.
The Upper Tribunal has now concluded that the settlement payment was a termination payment taxable under section 401 and therefore was taxable unless proved otherwise, and was not excepted under section 406 as being a payment on account of injury to feelings in the context of the discrimination claim. In a helpful and relatively clear decision, the Upper Tribunal has brought together some useful strands of the case law and has confirmed that the treatment of injury to feelings compensation for discrimination depends on whether the discrimination is connected with the termination. In essence:-
- Injury to feelings compensation for discrimination occurring during employment (even if it is paid on termination) is not earnings, is not a taxable termination payment and can be paid without deduction of tax.
- On the other hand, compensation for discrimination connected with the termination will be taxable – as a termination payment under section 401. The Upper Tribunal accepted that section 401 is both clear and broad in its definitions – there is nothing in its terms which exclues injury to feelings payments from its ambit. Therefore, once it is established that there is a factual connection between the payment and the termination, the payment is caught by section 401 and is taxable unless excepted under section 406;
- Turning then to the exception: the Tribunal concluded that section 406 cannot be read as exempting all payments made by an employer in respect of an injury to an employee: one needs (following Horner, rather than Timothy James) to read the section in context, and that context includes the words ‘death and disability’. In other words, a restrictive definition was applied: the word ‘injury’ in section 406 relates to a ‘medical condition’ resulting in termination of employment, and hence compensation for injury to feelings is not a relevant exception from the requirement to tax under section 401.
So, in summary, we end up with confirmation that the tax treatment of compensation for discrimination depends on a sometimes delicate factual matrix – ie, whether the discrimination is connected with the termination. If it is, it will be taxable as a termination payment. Employers and practitioners alike will need to look carefully at how this is dealt with in settlement documentation – clear apportionment of any compensation for discrimination taking place during employment is vital. In addition, one wonders the extent to which lawyers acting for employees will now seek to push personal injury claims rather than discrimination arguments, given the differential tax treatment.