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.

In a recent case (R Jones, J Jones v HMRC) that initially appears surprising, the First-Tier Tribunal determined that dividends declared by a recruitment consultancy company, which subsequently went into insolvent liquidation, were not unlawful.

The company had been struggling but they were still forecast to make profits at the time dividends were declared.  Unexpectedly, the company’s invoice finance providers demanded immediate repayment of sums owed.  It appears that this was what forced the company into liquidation as they were not able to obtain the funds on demand and were unable to find alternative finance.

On appointing liquidators, the directors were advised to reclassify the sums paid as dividends as salary as there was a risk that they could be unlawful.  There was no evidence presented as to why they believed this to be the case, and the directors admitted to not fully understanding the advice given.  This reclassification took place, but the accounts and company records were not fully updated to reflect this.

The directors declared the salaries on their tax returns, but stated that tax had been deducted, which was not the case as when the payments were made, they were treated as dividends.  HMRC argued there had been a wilful failure by the business to deduct PAYE and National Insurance on these payments of salary, and were therefore seeking to recover the tax from Mr and Mrs Jones.

The directors appealed arguing that the payments had been intended as interim dividends.

The First-tier Tribunal decided that the reclassification amounted to “nothing more than a flawed analysis of the transactions which had taken place”.  The sums were clearly intended as dividends and they did not see any reason as to why they should have been unlawful.  They did acknowledge that the position may have been different if the dividends were unlawful.

The taxpayers’ appeal was therefore allowed, with the sums taxable as dividends as originally intended.

This case highlights the importance of taking correct advice, and of ensuring that dividends are declared in a lawful manner with proper records made.  The taxpayers in this case were able to get the desired outcome, but the position would likely have been resolved more easily if proper advice was taken at the time.

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.

The question as to whether or not monies are taxable as employment income is a common area of dispute in tax.  However, the First Tier Tribunal case of Colin Collins v HMRC involved a particularly unusual set of circumstances to which the question needed to be applied.
The case itself involved the payment of $2 million by a former shareholder of a Company to the taxpayer who had worked for that Company, before subsequently leaving and later being re-employed under the new ownership.
The precise facts of the case led the Tribunal to consider that the payment amounted to a gift by the former shareholder. HM Revenue and Customs had contended that it was a payment in connection with the taxpayer’s former or current employment.
Of significant interest is that the Tribunal set out in their written judgement a list of key points that lead them to their decision:

  • Was the payment gratuitous?
  • Was the payment expected?
  • Was it proportionate (for example in terms of past salary)?
  • Was there any regularity in the payments?
  • Who made the payment?
  • Was there a time delay in making the payment and if so was this delay cosmetic?
  • What was the occasion/reason for the payment?

While the list is of interest, the old adage remains that each case must be considered on its own merits.

PA Holdings Limited constructed a complex arrangement in order to try and ensure employee bonuses were taxed as dividends rather than employment income.  The company paid a capital contribution into employee benefit trusts, out of which bonuses were paid to select employees in the form of dividends.

The First and Upper-tier tribunals decided that the payments were employment income under Schedule E and dividend income under Schedule F. The effect of this being that they were not chargeable to tax as employment income, only as dividends; but they were earnings for the purposes of NI contributions.

Both parties appealed to the Court of Appeal.  The Court of Appeal overturned the Upper Tier Tribunal ruling that income can be in both schedules E & F. The judge stated that if income falls within Schedule E, it is precluded from falling within Schedule F.

The Court found that the income fell within Schedule E as the amount of payment received by the employee was dictated by the employer.  Therefore the payments were remuneration for employment and subject to Income tax and NICs accordingly.