A recent First-Tier Tribunal raised an interesting point with regard to the rules on Termination Payments under ITEPA 2003, s.401.  These rules apply not only to compensation payments made on termination, but also a change in the duties of a person’s employment or a change in the earnings from a person’s employment, and can mean that the first £30,000 of such qualifying payments is exempt from Income Tax.

An important point to note however, is that these rules only apply where there is not already a tax charge under another heading per s.401(3).  In the case of payments made due to a change in duties this presents difficulties, as the payment could be taxed as normal employment income if the payments are found to be emoluments.

This is how the taxpayer in A Hill v HMRC (TC04480) came unstuck.  The taxpayer had his employment transferred under the Transfer of Undertakings Regulations 2006 but was not happy with the new conditions.  A compromise agreement was made under which each company paid him £15,000 in settlement of his complaints. He was required to continue working for the new company and would have to repay them both if he left within two years.

The taxpayer argued that the payments should be exempt under ITEPA 2003, s 403, however HMRC argued that they were taxable.

The First-tier Tribunal decided the payments were consideration for agreeing to accept a change in his contract of employment, however the fact he was required to continue working, and would have to repay the sums if he did not, showed they referred to his continuing employment. As such they were taxable as emoluments and not exempt.

A City trader recently won a case at the First-Tier Tribunal confirming that a payment of £600,000 from his former employers could be treated as tax free.  The catch comes in the fact that the payment was made as a settlement as compensation for racial discrimination; however the payment was in part calculated by reference to lost earnings.

In Mr A v HMRC, HMRC argued that because the payment had been calculated by reference to Mr A’s lost bonuses and earnings, it should be treated as taxable as earnings.  Mr A argued that the payment represented compensation in relation to a threatened race discrimination claim against his employers , and that therefore no tax should be due.

Mr A was eligible to benefit from the bank’s “discretionary bonus scheme”, and during his first 6 months made a profit of €3m for the bank, receiving a bonus of €50,000. During the next year he made a profit of €9.1m for a bonus of €125,000, which was later increased to €725,000 after he challenged it.

Mr A felt that the bonuses were disproportionately small compared to his colleagues, and that he had also been overlooked for promotions.  He made a claim under the Race Relations Act 1976 (now replaced by the Equality Act 2010).  Eventually the parties entered into a compromise agreement for full and final settlement. The amounts paid included a statutory redundancy payment of £1,650, an ex-gratia redundancy payment of £48,898 and the further compensation sum of £600,000.

Ultimately, the courts found in favour of Mr A, stating that “while the discrimination may have manifested itself through the way in which the employee was remunerated, the damages arise not because the employee was under-remunerated but because the underpayment was discriminatory.”  They found that the payments were made due to the fact that Mr A had been discriminated against and that the fact that they were calculated by reference to lost bonuses and earnings did not make the sums earnings.

It is interesting that a sum of £178,922 which was part of the £600,000 figure was acknowledged to be in respect of a bonus that was underpaid in error, however the Tribunal still felt that this fell within the overall discrimination claim as it would not have been paid without the claim.

The case could have interesting implications for compensation payments in the future and highlights the importance of reviewing the tax implications of transactions at the time based on the facts.  It remains to be seen whether HMRC will look to appeal this case at the Upper Tribunal.

In the First-Tier Tribunal case of K Moorthy (TC3952) the judge noted that the taxpayer ended up in a worse position regarding his compensation for loss loss of office following the decision than if he had accepted an earlier offer made by HMRC.

ITEPA 2003, s.401 catches payments made directly or indirectly in consideration of a termination of employment. Unfortunately, in this case the tribunal found that the entire sum of £200,000 which had been paid to the taxpayer fell within the scope of s.401.

Following redundancy in March 2010, the taxpayer argued that he was discriminated against because of his age and subsequently looked to take his case to an Employment Tribunal. As a result of mediation, the Company paid the taxpayer an ex gratia sum of £200,000 as compensation for loss of office and employment. This was paid in 2010/11 under an agreement that the first £30,000 was paid free of tax and the balance subject to a 20% tax deduction. The taxpayer claimed a refund of £34,000, on his tax return, stating the tax had already been deducted and that it should be fully exempt as it was paid to settle his discrimination claim and protect the company’s reputation.

HMRC considered the full amount to be taxable but by “concession and in order to try and reach agreement” offered to treat £60,000 as tax exempt. The taxpayer appealed because he felt the the full amount should be exempt. He also revealed that the Company had previously made a statutory redundancy payment of £10,640.

The taxpayer’s appeal was unfortunately dismissed with the judge ruling that the £30,000 exemption should be reduced to take into account the statutory redundancy payment of £10,640. Further the judge ruled HMRC’s additional £30,000 allowance was an ‘unlawful concession’ that the Tribunal could not take into account.

Clearly, the facts in each compensation for loss of office/employment case are different. As ever obtaining professional advice is sensible. It is possible that suitable advisors could have informed Mr Moorthy that the deal offered by HMRC was a good one and therefore saved him a substantial amount of tax.