Payments made to an individual as compensation for injury to feelings and reputations that are not connected with the termination of employment can be paid tax free. The recent case of A v HM Revenue & Customs (“HMRC”) has highlighted both the difficulties and possible opportunities for employers and employees who may seek to use such payments as a mutually tax efficient way to make termination payments.
The case concerned a trader who after claiming to have been constructively dismissed received a lump sum of £250,000 from his employer as settlement for his claim. The trader claimed £200,000 of the payment was tax free as it had been paid for injury to feelings and reputation and only £50,000 was taxable as a termination payment.
The Special Commissioner drew a distinction between compensation for injury to feelings and reputation arising pre-termination and arising in connection with termination. Whilst the payment for injury to feelings arising pre-termination was tax free, any payment covering injury to feelings and reputation in connection with termination was taxable as employment income. There is guidance from the Vento case on the amounts that can be awarded for injury to feelings, which the Special Commissioner took into account. Accordingly, only £10,000 was payable tax free as being attributable to pre-termination injury to feelings.
Typically, ex-gratia payments and other benefits received in connection with the termination of a person’s employment are chargeable to income tax as employment income. By virtue of an exemption the first £30,000 of such payments can be paid tax free. Damages for injury to feelings arising from events which occur pre-termination and are not connected with the termination can also be paid tax free.
The facts of the case
A bank trader resigned from his post after being told he would receive a final written warning following internal disciplinary proceedings. He believed the disciplinary proceedings were a sham and were being instigated to intimidate him following his whistleblowing allegations about the bank’s recruitment process involving senior bank officials.
The trader and his employer settled the dispute with an out of court settlement of £250,000. Although the settled sum of £250,000 was not particularised, the settlement agreement provided that the payment was “in respect of claims made in the Employment Tribunal application”. No specific amount was allocated to injury to feelings in either the Employment Tribunal application or the settlement agreement.
The bank, after allowing for the £30,000 tax free limit, subjected the remaining £220,000 to tax.
As payments of damages for injury to feelings that are not connected with termination of employment are not subject to tax, the trader sought repayment of the tax from HMRC, arguing:
- £200,000 of the payment was compensation for loss of reputation and injury to feelings resulting from the disciplinary proceedings and written warning, and therefore not taxable; and
- the balance of £50,000 was chargeable to income tax to the extent it exceeded £30,000.
HMRC disputed the trader’s claims and argued there was, as evidenced by the settlement agreement, a clear link between the compensation and termination of employment. HMRC believed the link was supported by the fact the trader’s claims, with the exception of the claim for injury to feelings, were stated in the Employment Tribunal application to be “by reason of dismissal”. Therefore, the payment was taxable as employment income.
Injury to feelings
Employers should be wary of allocating too high a figure for injury to feelings. When apportioning payments, the Employment Tribunals are guided by the Court of Appeal case of Vento v Chief Constable of West Yorkshire Police in determining the appropriate level of damages for injury to feelings.
Such payments are split into three bands:
- the top band is between £15,000 and £25,000. Sums in this range are awarded in the most serious cases, such as where there has been a lengthy campaign for discriminatory harassment on the grounds of sex or race. Only in the most exceptional case should an award exceed £25,000;
- the middle band of between £5,000 and £15,000 is used for serious cases, which do not merit an award in the highest band; and
- the low band of between £500 and £5,000 is for less serious cases, such as where the act of discrimination is an isolated or one-off occurrence.
Timing of injury to feelings
Following the case of Walker v Adams, HMRC’s guidance confirms that any part of the settlement that can reasonably be attributed to injury to feelings before the termination is not taxable as it is not “connected” with the termination, but any part of the settlement attributed to injury to feelings arising at or after the termination is taxable.
Decision
The Special Commissioner dismissed the trader’s argument and held that the payment was chargeable to income tax except for £10,000, which was fairly attributable to injury to feelings arising pre-termination. The £10,000 awarded for injury to feelings should not be seen as a benchmark set by the tribunal for injury to feelings. The figure was proposed by HMRC as part of their case in the tribunal, presumably as a means of settling the case in an efficient manner and whether this was an appropriate figure was not considered in detail by the Special Commissioner.
A higher apportionment of the payment to injury to feelings was not offered by HMRC nor granted by the Special Commissioner because, as the trader himself acknowledged in his claim, the damage to his reputation and injury to feelings flowed from his dismissal. As HMRC have made clear, the tax exemption only applies to pre-termination injury to feelings and reputations.
Planning points
Where employers are making payments for injury to feelings as part of an employee’s termination package, they should note the following points:
- any sum which is for injury to feelings should be calculated with regard to the Vento guidelines to ensure an excessive allocation is not made for tax purposes;
- the amount allocated for injury to feelings should be expressly decoupled from the termination payment;
- provided care is taken and the amount awarded for injury to feelings is proportionate and reasonable, there is scope to grant employees up to £55,000 tax free on the termination of employment. The £55,000 would consist of the £30,000 tax free limit for termination payments and the Vento top band of £25,000 for injury to feelings. However, falling into the top end of either element is likely to be difficult given the extent of employees contractual entitlements and the fact payments on termination of employment which are of a contractual nature are fully taxable. In cases where there is doubt in respect of the tax free figure allocated for injury to feelings the employers can protect their position by keeping a payment in escrow whilst HMRC approval is sought or by including an indemnity in the settlement agreement.
The current case shows that, whilst there are difficulties in using damages for injury to feelings and reputation as a tax efficient way of making termination payments, there are nevertheless opportunities to increase the amount of tax free payments to employees on termination in appropriate cases.
