The Upper Tribunal’s recent decision in Moorthy v HMRC [2010] UKUT 13 (TCC) has left many employment practitioners wondering how this affects the advice they give their employer and employee clients going forward, and what practical steps they should take to ensure tax compliance while protecting their clients’ best interests. Vicki Carr, editor in the Practical Law Tax team, answers some of the common employment practitioner questions likely to arise from the judgment.
Question
I understand that following the Upper Tribunal’s decision in Moorthy, as long as there is a connection between the payment and the termination, the payment is taxable. However, how close does that connection have to be? What about employees who suffer a prolonged period of discrimination which ultimately results in dismissal but doesn’t directly lead to it – will all of that compensation be taxable now (other than the £30k exemption)?
Answer
You are right, the Upper Tribunal in Moorthy confirmed that the whole of a termination payment that is paid in consideration, or in consequence of, or otherwise in connection with, the termination is taxable under section 401, ITEPA 2003. Importantly, it confirmed that, if such connection exists, the reason for the payment, whether to compensate for injury to feelings, for financial loss or for some other reason is not relevant. (Accordingly, the First-tier Tribunal’s pecuniary/non-pecuniary method of apportioning a termination payment in Oti-Obihara can no longer be relied on.)
In Moorthy, the discrimination (age discrimination) occurred only as part of the termination. Therefore, the entire payment fell within section 401.
At the other extreme, if an employer pays compensation for discrimination and there is no termination (or change in duties or earnings), the payment will not be caught by section 401.
If the discrimination occurs only during the course of employment and there is an unconnected termination, the part of the settlement payment that relates to the discrimination will not be caught by section 401. This was the situation in Mr A v HMRC and HMRC accepted that the payment was not caught by section 401. (HMRC argued that the payment was earnings, not a termination payment.)
The position is less clear if there is a prolonged period of discrimination, which ultimately results in the termination of the employee’s employment. The Upper Tribunal in Moorthy emphasised that the test is whether the necessary connection exists between the payment and the termination (the pecuniary or non-pecuniary nature of the payment being irrelevant). This suggests that if discrimination causes the termination, payment to compensate for discrimination would be connected with the termination. However, the tribunal accepted that compensation can be apportioned between events occurring before and after termination so that they can be treated differently for tax purposes. HMRC has long accepted this apportionment approach. Accordingly, if a specific sum is allocated solely to compensate for discrimination occurring during employment, that part should likewise not be caught by section 401. Conversely, if the entire settlement payment relates to loss of future earnings, HMRC will seek to tax the entire payment under section 401. HMRC confirms this in its guidance, see EIM12965 Termination payments and benefits: Statutory compensation for discrimination and compensation for hurt feelings. The government is considering changing its position on this (see paragraph 4.41 of the consultation on simplifying tax and NICs on termination payments).
The problem in practice is that employers will often prefer to make a single payment settling all claims (without any admission of liability) rather than apportion the payment between the various heads of claim (especially if discrimination is alleged). However, if such an allocation is possible, including a sum under the head “compensation for discrimination during employment” will clearly be helpful (although HMRC may challenge allocations that are not, in its view, reasonable). If separate allocation is not possible, all is not lost. The First-tier Tribunal in Mr A recognised the practical difficulties in reaching settlements and in reaching its decision focused on the likely motives of the employer rather than the strict wording of the settlement agreement.
In all cases, employees will need a clear and consistent evidence trail establishing his or her pre-termination discrimination claim.
Question
Can compensation for financial loss during employment caused by discrimination still be paid tax free (e.g. lost bonuses, pay rises etc) like in the Mr A case?
Answer
The Upper Tribunal’s decision in Moorthy does not disturb the First-tier Tribunal’s decision in Mr A.
Nevertheless, the First-tier Tribunal’s decision in Mr A must be applied with caution. As a First-tier Tribunal decision it is not binding although it is of persuasive authority. Accordingly, there is no binding judicial authority for the proposition that damages for underpaid salary or bonus due to discrimination during employment is not taxable as earnings. (While HMRC has not appealed the decision, this should not be taken as tacit acceptance of it.) Conversely, arrears of pay is generally taxable as earnings . The line between the two is a fine one and, in these circumstances, it is likely that HMRC will continue to challenge compensation payments calculated by reference to underpaid salary or bonus.
That said, HMRC would find it more difficult to challenge the tax treatment of the payment if:
- A sum (which is calculated by reference to financial loss as well as injury to feelings ) is allocated in the settlement agreement as compensation for discrimination during employment.
- There is no specific allocation, but there is evidence of discrimination and the employee has consistently alleged discrimination (as opposed to bringing a claim for breach of contract, for example). The First-tier Tribunal in Mr A accepted as a “sensible starting position” that a payment in settlement of a claim should bear the same tax character as the claim which it is in settlement of. (HMRC did not object to this proposition.)
Question
What if part of the injury to feelings compensation is to compensate for personal injury caused by the discrimination (often psychiatric injury) – is that part now taxable or is it exempt under section 406?
Answer
The Upper Tribunal in Moorthy determined that “injury” in the exception to the tax charge on termination payments (section 406, ITEPA 2003) means a medical condition that results in the termination of employment. The tribunal accepted that injury in section 406 includes personal injury including psychiatric illness. Accordingly, compensation for psychiatric injury would be exempt from tax.
Question
Do we need to change the wording of our settlement agreement?
Answer
It will depend on who you are acting for.
It is highly unlikely that an employer will want to apportion an amount to discrimination even though that’s a better position for the employee. This will be both for sensitivity reasons but also, possibly, for tax reasons (a discrimination payment may not be tax deductible for the employer whereas earnings or a redundancy payment is).
However, if you are acting for an employee, you may want to argue that the wording provides for a compensation sum under the head “compensation for discrimination during employment” (assuming that a case could be made to sustain this should HMRC question the taxable status of the payment).
Question
Do you think the EAT will follow the Upper Tribunal’s decision in Moorthy even though it isn’t strictly bound to do so?
Answer
The EAT will undoubtedly review both the EAT and Upper Tribunal’s decisions and decide which it prefers. On balance, given the Upper Tribunal’s very careful analysis of the EATs’ decisions, I think the EAT would follow Moorthy. (It is notable that the EAT has itself referred to the EAT’s decision in Orthet as “controversial”, see Yorkshire Housing Ltd v Cuerden UKEAT/0397/09 paragraph 29).
Question
Should I tell my employer clients to deduct all potential tax on settlement payments at source now and tell their employees to try and reclaim it back from HMRC?
Answer
Employers will certainly want to avoid liability for underpaid PAYE or NICs (and related penalties and interest) and that approach would protect the employer’s position (and arguably gives the employer a better chance to argue that the payment is tax deductible). However, commercially, the employer may not wish to run the risk of the matter going to tribunal with the prospect of the employer being named in public tax tribunal proceedings. For this reason, employers may prefer to keep control of potential proceedings, but protect its position with a full tax indemnity from the ex-employee. All approaches should be considered.
Question
If acting for an employee, do we need to change our schedule of loss and assume that all awards or settlement sums are taxable and gross up accordingly?
Answer
If the award or settlement sum relates to the termination, it will be taxable (and grossing up should be applied) unless a specific exemption applies (for example, any part of the damages payment that relates to personal injury (psychiatric illness)).
Question
What about discrimination compensation for injury to feelings where there is no termination?
Answer
The position hasn’t changed: HMRC accepts that this is not taxable or subject to NICs.
