To tax or not to tax? The tax status of injury to feelings payments

Thrings solicitor Andrew Strong comments:

Whether it is offshore giants like Google, Amazon or Facebook or bankers' bonuses, the question of tax never seems to be out of the headlines for long. The same is equally true in the employment sphere, where the Government is seeking to clamp down on income tax evasion and to close the avoidance loopholes. In a move which could have an impact on all manner of employees – from the most senior to the most junior – the Government is also reviewing the status of the current exemption from taxation on the first £30,000 paid in compensation for termination of employment.

In this context, a recent decision by the Upper Tribunal Tax and Chancery Chamber is relevant.

There has been a long-running debate amongst employment and tax lawyers as to whether payments made under settlement agreements in respect of injury to feelings arising from alleged acts of discrimination are taxable as income in the normal fashion, or whether they are, in fact, totally exempt by virtue of section 406 of the Income Tax (Earnings and Pensions) Act 2003 (the Act). This section provides that payments on account of the employee's injury or disability should not be subjected to income tax. Many employment lawyers acting for employees have argued that this applies to injury to feelings payments and have sought to structure settlement agreements accordingly.

In the case of Moorthy v The Commissioners for Her Majesty's Revenue and Customs, M had entered into a settlement agreement with his former employer resolving claims for unfair dismissal and age discrimination. The parties agreed a compensation payment of £200,000, the first £30,000 of which the employer paid without deduction of tax in the usual way. M then sought a rebate from HMRC in respect of the income tax the employer had deducted in respect of the balance, arguing that because the payment was made in compensation for the injury to feelings he had suffered.

This argument was rejected by the Upper Tribunal which held that the tax status of compensation payments under a settlement agreement depends on whether a connection, however loose, exists with the termination of employment. If such a connection exists, the first £30,000 paid to an employee in compensation can be paid tax free but the balance must be taxed in the usual way.

In the present case, there was no suggestion that M had a claim for injury to feelings arising from a standalone act of discrimination prior to the termination of his employment. The dismissal was the act of discrimination, and as such the subsequent injury to M's feelings was connected to the termination of his employment. The employer was right to tax the balance above £30,000.

Limiting the scope to argue tax-free status yet further, the Upper Tribunal interpreted “injury” in section 406 of the Act as relating solely to medical conditions, thereby excluding pure injury to feelings.

Whilst we are at pains to stress that there is no link between the Upper Tribunal’s finding in this case and the Government’s ongoing review of the tax system as a whole, this decision will add to the growing sense that a shift is taking place in the established position with regard to the taxation of settlement payments.

The scale of this shift will only become apparent when the Government finalises its position with regard to the current £30,000 exemption and publishes solid proposals for reform. Ideas trailed to date include replacing the current exemption with a new exemption in cases of redundancy, the value of which would be linked to length of service. The Government’s consultation on this reform closed last summer and a response to the consultation is due in 2016.

We will, of course write with further updates when the position becomes clearer.

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