Settlement Payments and Tax

Settlement Agreements are a popular way of resolving employment disputes or potential employment disputes, and for employees the fact that the compensation can be received tax free is often appealing.

The payments that qualify for the tax free exemption can often be complicated and in a recent case decided by the Tax Chamber of the First-Tier Tribunal the taxable status of a payment for potential discrimination claims has been considered.

The Law

Certain elements of compensation are subject to tax, and some are covered by a £30,000 tax free exemption. The different elements are as follows:

• Payment which consists of back pay for work done will be regarded as earnings and therefore taxable in full under section 62 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003).
• Compensation for losses resulting from discrimination are not taxable.
• Compensation for the termination of employment or for a change in duties or earnings, is tax-free for the first £30,000, after which it is taxable under section 401 of ITEPA 2003.
• Injury to feelings awards may or may not be subject to tax.

The tax position is the same whether or not the compensation is agreed under a Settlement Agreement or is awarded by an Employment Tribunal. Where compensation is awarded by an Employment Tribunal and it is taxable the award will be grossed up so that the employee receives, in their pocket, the amount that they would have received net in any event.

The Facts

In this case the employee remained anonymous and therefore is referred to as Mr A. Mr A worked as a trader for a bank and as part of his remuneration package he was entitled to receive a discretionary bonus. In November 2007 he raised a grievance about his bonus as he was unhappy about the amount received.

One of the claims that Mr A made in his grievance was that he received a lower bonus than colleagues because of his race. Unhappy with the outcome of his grievance Mr A served a discrimination questionnaire on his employer. At around the same time the bank were making redundancies and Mr A was informed that he would be made redundant.

Mr A was paid;

£1,650 statutory redundancy;

£48,898 ex-gratia redundancy payment; and

£600,000 settlement for all outstanding and potential claims.

HMRC subsequently contacted the bank for an explanation and breakdown of the calculation of the £600,000 paid.

The bank stated that whilst they disputed any claim for discrimination they had accepted that there was certain merit in Mr A’s claims and therefore there was a risk of litigation. If successful then Mr A may have been able to claim some higher bonus payment.

HMRC took the view from this explanation that the payment should be taxed as earnings from employment under S.62 ITEPA, as it was designed to cover potential shortfalls in salary and bonus.

Mr A appealed against that assessment to the First-Tier Tribunal, arguing that the sum in fact represented compensation in respect of his threatened race discrimination claim.

The Decision

The Tribunal agreed with Mr A’s argument that the payment was for compensation for his potential claims rather than payment in return for his services. Therefore the money could not be considered as earnings.

Although a potential underpayment of earnings would not have arisen if it were not for the fact that Mr A was an employee, which was not enough to bring the payment within the definition of ‘earnings’. The payment was received by Mr A because he was the victim of discrimination.

Points to Note

In the event that you are compromising any claims with an employee it is recommended that you advise them to seek independent tax advice about their individual circumstances. The taxable status of payments can be complicated and therefore you should avoid giving employees any advice.

I recommend that any Settlement Agreement contains a clause which states that the employee retains the liability for tax in the event that HMRC deem it is payable, and it will be up to the employee to dispute any payment with HMRC.

You can read the full judgement here

If you have any questions, comments or experience of the taxable status of settlement payments in practice then please leave a comment below or email alison@realemploymentlawadvice.co.uk