Taxation of compensation for discrimination

HMRC has changed its published guidance on the tax treatment of certain compensation payments for discrimination suffered by employees.  HMRC now takes the view that the nature of a payment will derive from the payment that it replaces such that many types of compensation payment for loss of earnings will now be treated as taxable as earnings. However, the new guidance leaves a number of questions unanswered and it appears that HMRC may be willing not to apply the new guidance in some cases until April 2021. Indeed, since there are now two contradictory decisions of the FTT on this subject, the position generally remains unclear and it is far from certain that HMRC's new guidance represents the correct approach.

Background

The First-tier Tribunal decision in Mr A v HMRC in 2015 established that a payment of compensation for discrimination could be paid entirely free of tax, on the basis set out below:

"When we pose the question: "Why did the employee receive the payment" the answer is not that it was in return for the employee's services but because it has been determined that the employer has acted unlawfully by discriminating against the employee. Where damages are calculated by reference to under-paid earnings, while the discrimination may have manifested itself through the way in which the employee was remunerated, the damages arise not because the employee was under remunerated but because the under payment was discriminatory. An award in these circumstances cannot in our view be described as a reward for services. The award is paid for some reason other than the employment and is not earnings."

HMRC did not appeal that judgment, and issued a number of clearances based on Mr A over the years that followed. Their published guidance did not reference Mr A itself, but was consistent with its outcome.

However, in the later case, Pettigrew v HMRC (2018), compensation paid to a part time judge for unequal pay compared to full time colleagues was treated as earnings on the basis that compensation should derive its character from the nature of the payment it replaces. Mr A was distinguished, albeit in a way which is far from clear:

"your circumstances can be distinguished from those in the case of A. The FTT found that the payment made to A was to compensate for an actual or potential action against discrimination. It was rejected that the payment was earnings despite the amount being calculated based on bonus payments. Furthermore, the tribunal made a finding of fact that the payment to A was not from his employment; it was not for past or future services.

Even though it was a payment from his employer, it was found that the source of the payment was something other than his employment. In that particular case it was for giving up any future action against his employer. In contrast you have received a lump sum payment representing arrears of earnings. In line with the decision in the Miller case, you were entitled to amounts of earnings in previous years despite what was included in your employment contract. These earnings have now been paid to you by way of a lump sum and are taxable as earnings."

Updated guidance

In January 2020, HMRC published updated guidance in its Employment Income Manual at EIM12965. The changes to HMRC's guidance appear to follow the decision in Pettigrew, although the old guidance also remains on their website, with the caveat that it "does not accurately reflect HMRC's view of the legislation in that it states that compensation payments for discrimination can only be taxable under s401 ITEPA 2003. It should not be relied upon for payments made after 5 April 2021."

The changes "reflect HMRC's view that compensation payments for discrimination may be taxable under provisions other than s.401 ITEPA in certain circumstances", although it is not clear what these circumstances are or in what other circumstances such compensation payments might not be so taxed.

Accordingly (depending on "the circumstances") HMRC states that compensation for discrimination occurring during the employment (to which s.401 ITEPA does not apply because the payment is not connected with termination) is potentially taxable. The guidance distinguishes between compensation for historic loss of earnings which is now likely to be taxable as earnings under s.62 ITEPA and compensation for injury to feelings which, if attributable solely to discrimination occurring before termination, should not be taxable.

Payments in respect of amounts which the employee would have been entitled to but for the discrimination may or may not be taxable as earnings, although based on HMRC's new guidance, it seems clear that HMRC will seek to apply the Pettigrew approach in a wider range of circumstances.

In circumstances involving the termination of an employment, then it is also necessary to consider whether the payments are taxable under s.401 ITEPA (which may benefit from a £30k exemption) which will be the case if the payment is "connected with" termination. Compensation for discrimination representing future loss of earnings (after termination) will be connected with termination and so s.401 will applies (even where discrimination led to termination or where termination itself was discriminatory). Compensation for historic loss of earnings (such as in gender discrimination and unequal pay situations) has no connection to the termination and s.401 will not apply, but, if the decision in Pettigrew prevails, s.62 will apply, in which case the compensation will be taxable as earnings.

Compensation payments for injury (eg if employer's actions have caused a mental health condition that affects the individual's ability to work) will be connected with termination as it arises from the end of the employment (and inability to take up similar employment elsewhere). Such payments will be within scope of s.401 but may qualify for exemption for payments made in respect of injury/disability under s.406(1)(b) ITEPA if the conditions are met

In the case of compensation for injury to feelings:

1. if it can reasonably be attributed solely to discrimination occurring before termination of employment, it should not be treated as connected with termination and should therefore be outside the scope of s.401 and not taxable;

2. if the termination itself is discriminatory (and there was no previous discrimination during the employment), it should fall within s.401.

If the termination is discriminatory and there has also been discrimination during the employment, it will be necessary to examine the facts to determine what the injury to feelings payment relates to, and apportion any payments as necessary.

Comment

Given that both Mr A and Pettigrew are of equal (that is to say, no) precedent value, and given that HMRC appear to indicate that the previous guidance can be relied upon until April 2021, it is unclear where this currently leaves matters. Further guidance from the higher courts may be needed to bring clarity to this area. In the meantime, it will be necessary to carefully consider any particular scenario and a favourable outcome may require the taxpayer to challenge HMRC's ruling that the payment is taxable.