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Taxation of injury to feelings payments

Posted on 4th February 2016
Case law

A compensation payment, paid under a settlement agreement, for injury to feelings connected with the termination of employment was taxable. This report explains why.

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Simon Quantrill Simon
Quantrill
Managing Partner Telephone: 01473 688100

only injuries that are linked to a medical condition that results in the termination of employment are inside the section 406 exception

Moorthy v HMRC [2016] Tax and Chancery Chamber of the Upper Tribunal

Background

Maximising the tax-free element of compensation payable under a settlement agreement is an important issue especially in discrimination cases. Limited options exist to increase the tax-free sum that can be paid over £30,000.

In discrimination cases, a regularly used tactic is to pay any injury to feelings award tax-free. This allows the employer to pay a larger tax-free sum to the employee and help secure agreed terms of settlement at no extra cost.

Notwithstanding relatively clear Employment Appeal Tribunal decisions which have been relied upon for many years, the HMRC has just won this case.  The Tax and Chancery Chamber of the Upper Tribunal concluded that an injury to feelings award cannot be paid tax-free if the discrimination is connected with the termination of employment. 

For the unlucky employee concerned his entire compensation payment of £200,000 is now subject to income tax.

Discrimination connected with the termination

Under section 406 (of the Income Tax (Earnings and Pensions) Act 2003) a termination payment ordinarily taxable under section 401, as it is linked to an employee’s termination of employment, can be paid tax-free if it is paid in connection with the termination of employment by the death of the employee or on account of injury to or disability of an employee.

In the Moorthy case, the alleged discrimination arose from the termination of employment itself.  The Upper Tribunal held the compensation was therefore taxable. It disagreed with the previous EAT case law which held that injury to feelings awards fell inside the definition of “injury”.  The Upper Tribunal concluded that only injuries that are linked to a medical condition that results in the termination of employment are inside the section 406 exception.

Discrimination not connected with termination

Discrimination, for example sex, race or age, that occurs before the employment comes to an end is not connected with termination and therefore is not taxable. The tricky bit for employers and employees, following this case, will be showing that the alleged discrimination is not connected with the termination and is therefore tax-free.

In practice

The approach taken by the Upper Tribunal may prove to be an expensive decision for employers. For example, employers trying to negotiate settlement of a discrimination claim can now expect the employee’s solicitor to request grossing up of the injury to feelings award so that the employee receives a net payment equivalent to the proposed amount of the injury to feelings award after tax.

Employers should now take extra care when looking at how much to pay for injury to feelings and on what basis. HMRC will be able to seek payment of unpaid tax from the employer rather than the employee (subject to any tax indemnity given by the employee in a settlement agreement).

This case also makes the wording of the settlement agreement even more important. Not only should the tax indemnity be correctly drafted, but it will now be important to ensure that settlement payments are appropriately apportioned to reflect the compensation for pre-termination discrimination. This is an issue the team at Quantrills will be looking at carefully with all future cases.

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