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Don’t Injure HMRC’s feelings

Mr Moorthy was made redundant in 2010. He brought an employment tribunal claim on the basis that his selection for redundancy was because of his age. He brought subsequent claims for age discrimination and unfair dismissal and sought compensation for loss of earnings and importantly for this decision, injury to feelings.

During settlement discussions, Mr Moorthy came to an agreement with his ex-employer that he would accept £200,000 under a settlement agreement. The sum was not broken down and no particular element was attributed to injury to feelings. The settlement agreement provided that the first £30,000 would be paid without deduction of income tax and the balance would be taxed at 20%.

When Mr Moorthy completed his tax return, he stated that the whole of the settlement sum should have been paid tax free and sought to reclaim tax deducted. HMRC disagreed.

On appeal to the Upper Tax Tribunal, it was found that the whole £200,000 payment fell to be taxed as a termination payment under s401 Income Tax (Earnings and Pensions) Act 2003 because it was made in connection with the termination of Mr Moorthy’s employment. It rejected arguments that the payment had been made in respect of events leading up to his dismissal, rather than the dismissal itself. 

The key message coming out of this decision is that the tax status of injury to feelings compensation payments for discrimination seems to depend on whether the discrimination is connected with the termination. Because in this case the discrimination was related to the dismissal (Mr Moorthy said he was selected for redundancy because of his age), the injury to feelings award was taxable. Had the injury to feelings discriminatory compensation payment been made in connection with discrimination that occurred before termination (even if paid on termination), it could have been paid free of tax as it would have been neither earnings nor a taxable termination payment.

What does this mean for you or your business?

This is a stark reminder to get legal advice when drawing up settlement agreements. It is important to carefully review the tax treatment of each and every element of compensation awarded to an employee for discrimination, including injury to feelings awards. 

What do you need to be doing now?

Think carefully about any settlement payments you are making to an employee. Remember where an injury to feelings payment relates to termination of employment, it is taxable. However, where compensation is paid for injury to feelings in respect of acts of discrimination occurring during employment, it should not be taxable.  

Difficulties can arise however where acts of discrimination occurred both during employment (not related to termination) and on termination. If this is the case legal advice should be taken as the injury to feelings payments should be separated out within any settlement agreement to best deal with possible tax liabilities in either scenario going forward.  

These notes have been prepared for the purpose of articles only. They should not be regarded as a substitute for taking legal advice.

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