Legal update - Injury to feelings payments are taxable if they arise out of the termination of employment

A recent case (Moorthy v HMRC) has reminded us of the correct tax treatment of termination payments. A payment for discrimination and/or injury to feelings was taxable as a termination payment because the payment was made in connection with the termination of Mr Moorthy’s employment. This case teaches us that if a compensation payment is going to be made, and it is not intended to be compensation for the termination of the employment, then in order to give the best possible chance of ensuring that this does not fall within a charge to income tax, the reason for the payment should be expressly stated and a separate amount allocated to this.  

Mr Moorthy was informed he was to be dismissed by reason of redundancy in March 2009.  Following a 12 month period of garden leave, his employment was terminated and he received his statutory redundancy payment (and the full amount fell within the £30,000 exemption to tax).  Mr Moorthy then commenced Employment Tribunal proceedings, alleging unfair dismissal and age discrimination.  The case ultimately settled by way of a compromise agreement, and Mr Moorthy received £200,000 by way of compensation for his loss of office, and the full £30,000 exemption to tax was applied.

This case highlights some important points of principle when considering the tax treatment of a compensation payment on termination of employment:

• The payment will be taxable if it is made directly or indirectly in consideration or in consequence of, or otherwise in connection with the termination of the employment.  The fact that the payments purpose may also be to compensate for discrimination, unfair dismissal, injury to feelings, redundancy and/or other financial loss was immaterial.
• If the compensation payment is made to an employee for discrimination, injury to feelings or to protect the employer’s reputation and it is not directly or indirectly in consideration of or in consequence of, or otherwise in connection with a termination, then it will normally not be taxable.
• The £30,000 tax exemption must be aggregated with other termination payments made by the same employer, whether or not they are made in the same tax year.  In Mr Moorthy’s case he had received a tax-free statutory redundancy payment in the previous tax year and this should have been deducted from the exemption to the subsequent termination payment.
• Before the matter appeared in front of the first-tier tribunal, HMRC had proposed to make a concession to allow a deduction of £30,000 for injury to feelings.  However, the first-tier tribunal held that it had no jurisdiction to allow such a deduction.

Ultimately, Mr Moorthy would have been better off financially if he had accepted HMRC’s concession, rather than pursuing the matter to the tribunal.