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Settling a taxing point about taxation of settlement agreements
If you are an advisor who only occasionally dabbles with tax issues in settlements for fear of having to delve into murky tax law, take note of a recent decision providing a lucid summary of the relevant principles. The case is also a cautionary tale for claimants challenging tax assessments as the claimant’s unsuccessful challenge before the First-Tier Tax Tribunal (FTT) resulted in a tax bill larger than the one sent to him by HMRC. If Oti-Obhihara  IRLR 386 and Orthet v Vince Cain  ICR 374 ring a distant bell from advising on settlements past, they should now be retuned to the sound of alarm bells as the FTT in Moorthy v HMRC  UKFTT 834 (TC) has doubted their correctness.
Mr Moorthy’s employment was terminated on 12 March 2010. He received a statutory redundancy payment of £10,640 (tax free) before the end of the 2009-10 tax year. He then issued ET proceedings claiming unfair dismissal and age discrimination. The complaints all related to the redundancy/dismissal process. The parties mediated in January 2011. This led to a compromise agreement under which it was agreed Mr Moorthy would be paid “an ex gratia payment of £200,000 by way of compensation for loss of office and employment”. There was no admission of liability and the agreement was in full and final settlement of the ET claims and any claim “the parties might have against each other ‘arising out of or connected with the employment or its termination’”. The compromise agreement did not spell out how the payment was to be divided in relation to the different heads of complaint.
It did however state that the first £30,000 was payable without deduction of income tax and that the balance would be subject to 20% tax deduction. The agreement also stated that the employer made “no warranty as to the taxable status of the payments made under this agreement”. Mr Moorthy promised to indemnify his former employer for any further tax they may be liable to pay HMRC. The £200,000 was paid in full in the 2010-2011 tax year.
Mr Moorthy filed a tax return claiming the £200,000 was exempt from tax and sought a refund of £33,883. His solicitors wrote to HMRC explaining why (primarily claiming it was not taxable because the payment was made for discrimination and to protect the former employer’s reputation, relying on Oti-Obihara). This triggered a formal inquiry. Correspondence between the parties continued for over a year. HMRC then issued a closure notice reducing the taxable income first by £30,000 under s.403 ITEPA then by a further £30,000 as a concession, reluctantly accepting that this could reflect damages for injury to feelings at the top Vento range. Mr Moorthy challenged this and sought a statutory review. The reviewing officer confirmed the decision. Mr Moorthy appealed to the FTT.
The FTT began by observing that s.401 ITEPA casts a wide net. It not only catches payments made directly in consideration of a termination, or directly in consequence of a termination, but indirect payments of either type and also extends to payments which are not even in consideration or in consequence of a termination but “otherwise in connection with” a termination. The FTT did not hesitate to find that s.401 caught the entire £200,000. The fact the payment was made for discrimination and to protect the employer’s reputation were immaterial.
In Oti-Obihara the Tribunal held that payment for discrimination was only taxable if discrimination was the cause of the termination and then only to the extent that the compensation was for financial loss occasioned by the termination. It proposed a methodology to calculate what was and was not taxable by: (a) isolating the amount which relates to “financial loss”, subjecting that to tax; (b) excluding from the tax “the balance being compensation for discrimination and other infringement of rights. (The Tribunal included in category (b) payments relating to the employee’s foreign law rights and the employer’s concern for its reputation and privacy.)
The FTT in Moorthy rejected this methodology. It also found that the EAT in Orthet misread the precursor provision to ITEPA. In Orthet the ET awarded £15,000 injury to feelings and the issue was whether the award was subject to tax. The EAT held that it was exempt, but as pointed out by the FTT in Moorthy, it did so relying on what is now s.406 ITEPA dealing with payments for injury and disability. The FTT held that s.406 does not cover injury to feelings and so Orthet was not correctly decided and could not be construed as authority for exempting payments made for injury to feelings from chargeable tax.
The FTT also cast doubt on the Court of Appeal decision in Norman v Yellow Pages  EWCA Civ 1395 where the court observed: “It is common ground that damages for injury to feelings are not generally subject to such a tax deduction.” The FTT noted that the Court of Appeal did not even look at any of the tax statutes and received no argument on the point. In the FTT’s view, Norman is of no value.
The FTT concluded that the s.401 is clear and that any payment made directly or indirectly in consideration or in consequence of, or otherwise in connection with a termination is taxable, unless it falls within the £30,000 exemption in s.403, the death//disability exemptions in s.406 or the other specified exemptions in ss.407-414A. This left the FTT with calculating Mr Moorthy’s tax liability taking into account: (a) the redundancy payment made in the previous tax year and the £30,000 tax exemption; (b) how the PAYE rules apply in such a case; (c) the status of HMRC’s concession on the further £30,000 for injury to feelings.
The FTT found that the redundancy payment made in the 2009-10 tax year counted towards the £30,000 exemption under s.403. This meant that when the settlement agreement was paid in the following tax year, Mr Moorthy only enjoyed an exemption up to £19,360. The FTT then turned to the convoluted provisions relating to PAYE. It concluded that the employer should have deducted basic rate tax on £200,000 minus the £19,360 exemption which remained in Mr Moorthy’s “exemption pot” under s.403. The upshot was that Mr Moorthy was entitled to a credit of £2,128 which his former employer should have deducted – he could benefit from this credit irrespective of whether HMRC sought to recover this sum from his former employer.
Finally, the FTT found that the additional £30,000 relief granted by HMRC and described as a “concession” had no statutory basis. Although there was conflicting case law on whether concessions are justiciable, the FTT held that even if it was justiciable the concession was unlawful.
- A redundancy payment made in a different tax year to when the settlement payment is made counts towards the £30,000 exemption;
- If payments and other benefits are received in different tax years the £30,000 is set against the amount of payments and other benefits received in earlier years before those received in later years;
- The parties’ views on the tax implications are irrelevant;
- There is no special free-standing tax relief for payments made for injury to feelings or to protect an employer’s reputation/privacy;
- Parties to settlement agreements should be alert to what the payment relates to. If taxed incorrectly, particularly in high value settlements, the claimant will be liable for his tax shortfall and HMRC can go after the employer for their incorrect deductions.
Link to Moorthy v HMRC Posted 12 Dec 2014