Thu, 18 Sep 2014
Anthony Korn reports on the recent judgment of First Tier Tribunal Tax Chamber in Moorthy v The Commissioners for Her Majesty’s Revenue and Customs (TCO3952).
For a long time it has been unclear whether or not awards of compensation for injury to feelings are taxable. The answer given by the First Tier Tribunal Tax Chamber in Moorthy v the Commissioners for Her Majesty’s Revenue and Customs is that in so far as such an award by itself, or in combination with an award for loss of earnings, exceeds the £30,000 tax exemption, it is taxable. The same principle applies to settlements.
Relevant background
M was made redundant from his employment with Jacobs Engineering (UK) Ltd on 12 March 2012. He subsequently issued proceedings in an employment tribunal complaining of age discrimination and unfair dismissal. In essence, his complaint was that he had been selected for redundancy because of his age. He asserted that had he not been discriminated against, he would have worked to the age of 65 (if not beyond). He sought a basic award, compensation for financial loss, an award for injury to feelings and interest.
As a result of a successful mediation, M’s previous employers agreed to pay him an ex-gratia payment of £200,000 without admission of liability. The sum was not broken down in the sense that no particular sum was attributable to injury to feelings or any other non-pecuniary loss. The agreement stated that the “first £30,000… will be paid to M without deduction of income tax”. This failed to take account of the fact that M had already received an enhanced redundancy payment of £10,640 (which happened to fall within the previous tax year).
M completed his 2010/2011 tax return on line. Under ‘pay from employment’ he entered £200,000 and under ‘taken off pay’ in box 1 he entered £34,000 and under the heading ‘employment expenses’ he entered £200,000. He asked for the refund of £34,000 from the tax that had been deducted under PAYE as he said he had been advised that the settlement was tax free. His solicitors subsequently wrote to HMRC asserting that the full £200,000 was tax free partly on the basis that payments made under the settlement agreement was not taxable. HMRC issued a “closure notice” reducing the taxable income by £30,000 and also, by way of concession was prepared to reduce the taxable income by a further £30,000 representing the maximum Vento award for injury to feelings. Perhaps surprisingly, M did not accept the Revenue’s concession and continued to argue that the whole of the settlement was not taxable relying on the Tax Tribunal’s judgment in in Oti-Obihara [2011] IRLR 386. It was also suggested that the payments were not taxable because “it was made to protect he employer’s reputation”.
Relevant statutory provision
In the course of her judgment, Judge Anne Redston referred to Section 401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) which states that this chapter applies to payment and other benefits which are received directly or indirectly in consideration or inconsequence of, or otherwise in connection with “(a) the termination of a person’s employment”. She also referred to Section 403 (which sets out the basis for the £30,000 exemption), Section 404 which describes how the £30,000 threshold applies and section 406 which excludes payments for death or disability from Section 401.
The Judge’s reasoning
In essence, the Tribunal concluded that the entire payment fell to be considered under Section 401 of ITEPA because it was made in connection with the termination of M’s employment.
The Tribunal said that there was a “clear connection between his termination and the selection process, and a connection too, between his compensation payment and the discrimination which he alleges took place”.
The Tribunal rejected the argument that the payment had been made for the events leading up to M’s dismissal rather than the dismissal itself. The Tribunal doubted whether in fact M had suffered any injury to feelings before he was advised that he was at risk of redundancy and in so far as he had suffered such injury, this was attributable to the dismissal.
Turning to the previous case law, the Judge ruled that none of the authorities placed before the Tribunal established that payments for injury to feelings were not taxable if made in connection with the termination of employment. In so far as some authorities suggested otherwise, these cases were wrongly decided.
The Judge concluded that the point had not been argued in Walker v Adams [2003] SPC 344 because it had been conceded that the award for injury to feeling of £12,500 was not taxable by HMRC. Furthermore, in Oti-Obihara the Tax Tribunal had mistakenly relied on the concession in Walker to support its conclusion that compensation for injury to feelings was not taxable “without further analysis”. The Tribunal dismissed the EAT’s ruling in Vince-Cain [2004] IRLR 857 on the basis that the EAT’s ruling “rests on its misreading of ITEPA” and therefore considered the EAT’s ruling to be “confused about the underlying statutory provision” and “unreliable”.
The Tribunal concluded that “in our judgment the statute is plain. Any payment which is made ‘directly or indirectly in consideration or in consequence of, or otherwise in connection with’ a termination is taxable, unless it fall within the £30,000 exemption in s 403, the death/disability exemption in s 406 or the other specified exemptions in ss 407-414A”.
It was accepted that the exemption for death or disability in s. 403 did not apply in the present case because there was no identified medical condition, either physical, mental or psychological, which in whole or part prevented M from carrying out the duties of the employment (Horner v Hasted [1995] STC 766).
The Tribunal pointed out that in the present case M had already used up part of the £30,000 when he received his enhanced redundancy payment of £10, 640, so only £19,360 of the £30,000 exemption remained and, also ruled for the reasons explained in the judgment, that the “concession” made by the HMRC was not binding. Furthermore, as is made clear by Section 404(4) of ITEPA ‘if payments and other benefits are received in different tax years, the £30,000 is set against the amount of payments and other benefits received in earlier years before those received in later years’ In other words, the fact that these payments were spread over two tax years did not entitle M to a further £30,000 exempt from tax.
The overall outcome was that the full £200,000 fell within Section 401, that the exemption allowed by Section 403 was reduced to £19,360 and that the Tribunal had no power to allow further relief of £30,000, therefore the total taxable income was £180,640..
Implications
In the absence of a successful appeal, which seems unlikely in the light of the cogent reasons given by the Tribunal, it should be assumed from now on that compensation for injury to feelings either by way of a tribunal award where the discriminatory act relied on is dismissal or in a settlement agreement made in connection with the termination of employment, is taxable in so far as the overall award or agreement exceeds the £30,000 exemption.
In terms of tribunal awards,, this means that award for injury to feeling should, where appropriate, be gross up in accordance with the principle in Shove v Downs Surgical Plc [1984] IRLR 17.
The tax implications of any settlement agreement will need to be considered by both sides.
It is likely that the same principle will apply to awards for injury to health other than where the injury is so severe that the former employee is regarded as having a disability within the meaning of Section 403 of ITEPA. At the very least, it is advisable to apportion any settlement to identify and distinguish any payment for injury to health from payments for loss of earnings and other non-pecuniary losses.
The ruling will not apply to awards for non-pecuniary loss suffered for unlawful discrimination during employment. The extent to which it may extend to awards for other pre-dismissal detriments will depend on the circumstances and the extent to which the injury is caused by dismissal.
The judgment is also a useful reminder that other payments made on termination may “use up” the £30,000 exemption and that any concessions made by HMRC are not binding.
Please click here to view Anthony Korn's profile.
