A recent Upper Tribunal (UT) case has clarified the tax treatment of termination payments and compensation for injury to feelings. In Moorthy v Revenue and Customs Commissioners, the UT has confirmed that, aside from the usual £30,000 exemption, generally speaking, any compensation received in connection with termination of employment is taxable under section 401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA). This is the case even where the payment is made to compensate for injury to feelings arising from discriminatory treatment.
Section 401 provides that “payments and other benefits received directly or indirectly in consideration, or in consequence, of, or otherwise in connection with, the termination of a person’s employment” are chargeable to income tax. There is a general exemption for the first £30,000 of such payments, plus some specific exemptions (contained in sections 405 – 414A).
In this case the taxpayer had claimed that, as the payment was a settlement from his former employer in respect of an age discrimination claim, it represented ‘injury to feelings’ - and should fall out of income tax by virtue of one such exemption – that in section 406 ITEPA (Exception for death or disability payments and benefits). Having considered this issue – and in particular previous conflicting case law – the UT concluded that the exemption at s.406 does not provide a general exemption for payments “on account of injury”, but only applies to medical conditions which render the individual unable to continue in their employment.
The UT also highlighted the deliberately broad drafting of section 401. Where a payment satisfies the criteria of being “received directly or indirectly in consideration, or in consequence of, or otherwise in connection with” the termination of employment, it does not matter if it has another purpose (such as being compensation). This brings the large majority of such payments within the charge to tax.
The discrimination giving rise to the payment in this case was directly related to the termination of the individual’s employment. As found in the case of A v HMRC (which we reported in Weekly Tax Matters last year), payments to compensate for discrimination during the period of employment may (even when paid on termination) not be taxable either as general earnings or under the termination payments rules in s401. The issues are complex – particularly as one payment can include several elements which may be taxed differently - and it is important that employers take appropriate advice to ensure that amounts are correctly treated for employment tax purposes.
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