Injury to feelings compensation and tax: settlement agreements

Q:  “Is my payment for injury to feelings exempt from tax?”

Gemma Sherbourne, Solicitor at Schofield Sweeney answers…..

This is a question which was answered recently – at least in part – by the Upper Tax Tribunal in the case of Moorthy v HMRC.  

Background

Mr Moorthy received £200,000 under a settlement agreement, which was said to be by way of ‘compensation for loss of office and employment’.  He tried to argue that the full £200,000 should be exempt from tax on the basis that either:

(a) it was not paid in connection with the termination of his employment (and was therefore not chargeable to tax under section 401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA)), or

(b) if it was earnings under section 401, it should be exempt from tax under section 406 as it was paid ‘on account of an injury to an employee’ – being injury to feelings arising from discrimination.  

HMRC argued that the payment was taxable under section 401 ITEPA.

Decision

The Upper Tribunal found, quite simply, that section 401 of ITEPA will apply to ‘all payments and other benefits that are received directly or indirectly in consideration or in consequence of, or otherwise in connection with the termination of a person’s employment’.  This means that any such payments, including payments for injury to feelings, will be taxed in accordance with the normal rules on termination payments – that is, the first £30,000 can be paid without deduction of tax, and any payments in excess of this amount will be taxable in the normal way.  

The Tribunal decided that tax exempt payments for an ‘injury’ under section 406, means payments for personal injury.  The Tribunal concluded that ‘injury’ in this context means a medical condition that results in the termination of employment or a change in duties or earnings related to the employment.

Whilst ‘injury to feelings’ could be a cause of such a relevant injury – such as a psychiatric illness – ‘injury to feelings’ on its own was not sufficient for this provision to kick in.  Payments for injury to feelings would not therefore be exempt from tax under this heading.

Discrimination prior to termination

The Upper Tribunal did note that there was a distinction to be drawn between payments of compensation relating to discrimination before termination, and compensation paid in connection with termination.  

Compensation for discrimination which occurred before termination would not be considered as earnings under ITEPA and would not therefore be liable to tax.  However, compensation paid in connection with termination – even if related to discrimination – would count as earnings and so would be liable to tax under section 401.  If compensation is to be paid for both, it is therefore necessary for such compensation to be apportioned between events which occurred before and after termination so that they can be treated differently for tax purposes.

Conclusion

Compensation for injury to feelings will normally be liable to tax unless:

1.it relates to discrimination during the employment, rather than in consideration or in consequence of, or otherwise connected with termination; or

2.the ‘injury’ to feelings is so severe as to amount to a psychological injury which has led to the termination of employment or a change in duties or earnings.

In our experience, it is rare for an employer to agree to apportion part of a payment under a settlement agreement to discrimination during the employment – not least as this would necessitate an admission by the employer that discrimination has taken place.  However, if this does apply, it is sensible to request that such payments are apportioned accordingly – and to be clear in the agreement as to how this apportionment has been made – so as to increase the chances of HMRC accepting that such a payment should not be liable to tax.

Answer given and dated on 26 February 2016.

By Gemma Sherbourne, Solicitor.

Go to Settlement Agreements for more Q&As

 


IMPORTANT: The contents of this article are for guidance only and do not amount to legal advice.

helping employees with settlement agreements since 2013