The tax treatment of settlement payments: Are payments made to employees on account of injury to feelings, discrimination or termination of employment, subject to tax?

5 April 2016

In the Upper Tribunal (Tax and Chancery Chamber) case of Moorthy v Commissioners for HMRC, the Upper Tribunal overruled earlier Employment Appeal Tribunal decisions in relation to the taxable status of payments made on account of injury to feelings and provided guidance on the taxable status of payments made on account of injury to feelings, discrimination or termination of employment. It was held that “where payments are made directly or indirectly in consideration or in consequence of, or otherwise in connection with the termination of employment”, they are subject to tax. Therefore, any compensation received in connection with termination of employment is taxable (unless an exemption is applicable such as the usual £30,000 exemption, or the injury/disability exemption).

What does this case mean for employers?

  • Where a payment is made in connection with the termination of employment, the payment is taxable regardless of any other reason for the payment. This includes payments for financial loss, injury to feelings arising from discrimination, protection of the employer’s reputation or otherwise. Therefore employers should deduct tax on the full amount of any compensation payment made in connection with the termination of employment (less the £30,000 tax free sum, where applicable).
  • Payments which are made “on account of injury to, or disability of, an employee” are not subject to tax. The case of Horner v Hasted remains good law on the definition of this exemption and therefore in order to benefit from this exemption the employee must be able to prove that he/she has suffered from a medical condition (which does not include injury to feelings) which has resulted in the termination of employment or a change in employment duties or earnings. If an employee wishes to benefit from this “disability” tax exemption, then clearance should ideally be sought from HMRC, before the payment is made to the employee. It is useful to support any such application with medical evidence, which proves both the fact of the disability and that that was the reason for the payment.
  • If tax has not been paid correctly, then as long as no prior clearance has been obtained, HMRC can recover from the employer any unpaid tax going back four years.
  • It is possible to argue that where compensation is paid to reflect discrimination that was not connected to the termination of employment, this should not be taxable. However, to benefit from this exemption, there must be clear evidence of the fact that the discrimination complained of took place prior to the termination of employment. Settlement agreements should show how the payment has arisen, without a link to the termination.
  • Where discriminatory treatment allegedly takes place both during employment and on the termination of employment, employers should apportion the compensation to reflect the discrimination during employment (which can be paid tax free) and the termination-related discriminatory treatment (which is subject to tax, less the £30,000 exemption, where applicable).
  • If any payment is being apportioned for injury to feelings (unrelated to the termination), then in order to benefit from a tax exemption, the amount must be realistic and consistent with both the guidance in Chief Constable of West Yorkshire Police v Vento and the medical evidence.

Further information

Should you have any questions about the issues raised in this blog post please contact Moira Campbell or a member of our employment team.

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