Taxation of settlement payments and agreed costs

The Court of Appeal has overturned the earlier decision of the Upper Tribunal in a case concerning the calculation of taxable earnings where part of the payment under a settlement agreement was made by an employer directly to the claimants’ advisers as a success fee: HMRC v Murphy [2022] EWCA 1112. Despite being paid to the claimants’ legal advisers, the sums were still part of the global settlement in relation to the claimants’ action for unpaid overtime and other allowances and as such taxable.

In particular, the Court of Appeal has rejected the Upper Tribunal’s analysis that sums in respect of legal expenses were not taxable earnings as they did not fall to be treated as “profit” for the purposes of ITEPA 2003 s.62(2)(b).

Background

Mr Murphy was a police officer with the Metropolitan Police Service (the Met). The dispute concerned the tax treatment of certain payments made by the Met for the account of Mr Murphy and a number of other police officers pursuant to a settlement agreement in respect of claims brought by the officers for unpaid overtime and other allowances.

To fund the legal proceedings against the Met, the claimants entered into a Damages-Based Agreement (the DBA) with a firm of solicitors and counsel. Under the terms of the DBA, solicitors and counsel agreed to act for the claimants in return for a “Success Fee” which was calculated as a percentage of any sum paid by the Met to settle the claim or any damages awarded to the claimants. Each of the claimants also entered into an insurance contract with Temple Legal Protection Limited (Temple). Under the terms of the insurance contract, Temple insured the claimants against the risk of having to pay the Met’s legal costs if the claimants lost all or part of their claim.

The dispute between the Met and the claimants was eventually settled and a Settlement Agreement was entered into. The Settlement Agreement included provision for the Met to pay to the claimants £4.2m plus agreed costs. The Settlement Agreement also included provision (clause 3.3) for the Met to use part of the £4.2m to pay the Success Fee and the insurance costs directly to solicitors, counsel and Temple before paying the remainder to the claimants, subject to PAYE and NICs (which it withheld).

HMRC accepted that the agreed costs were not “earnings” for tax purposes. However, HMRC contended that the whole of the remaining settlement payment of £4.2m was correctly described as earnings and was subject to tax. In contrast, the claimants argued that the amount of the Success Fee and the insurance costs under clause 3.3 of the Settlement Agreement were not properly described as earnings and were not taxable as employment income.

At first instance, the FTT agreed with HMRC’s analysis that, in essence, the whole of the £4.2m agreed settlement payment was earnings for tax purposes and it did not matter that the claimants were required to pay out of that amount the Success Fee and insurance costs. The Upper Tribunal has overturned the decision of the FTT. In particular, the Upper Tribunal considered that the FTT had paid insufficient attention to the wording of s.62(1)(b) and that the amounts paid in relation to the Success Fee and insurance did not fall to be treated as “profits”.

“Earnings” are defined in ITEPA 2003 s.62. In particular, s.62(2)(b) provides that “earnings", in relation to an employment, means… any gratuity or other profit or incidental benefit of any kind obtained by the employee. The FTT had focused on the question whether the amounts received by the claimants were “from the employment” and they had failed to focus on the question whether those amounts were correctly described as a “profit”.

Decision of the Court of Appeal

The Court of Appeal has overturned the decision of the Upper Tribunal.

The Court pointed out that there is a specific statutory framework in ITEPA 2003 to allow for deductions from taxable earnings. That framework contemplates that all earnings from a person’s employment are taxable, subject only to the allowable deductions provided for by ITEPA 2003 Part 5. It, therefore, made “no sense” for the word “profit” in s.62(2) to be given a meaning that involves taking into account deductions from payments received by the employee, particularly a deduction which would not be permitted under Part 5. Notably, the Success Fee and insurance premium would not be permissible deductions under those provisions.

It was clear in this case that the payment of £4.2m under the Settlement Agreement was taxable as earnings from the employment, paid as reward for the services performed under the employment.

Clause 3.3 of the Settlement Agreement provided for the Met to use part of the £4.2m settlement to pay amounts equal to the Success Fee and the insurance costs directly to solicitors, counsel and Temple before paying the remainder to the claimants, subject to PAYE and NICs (which it withheld). The Court of Appeal noted that Clause 3 made no difference to the character of the payment, as it was merely a mechanism for the discharge of the claimants' own obligations to third parties using the settlement monies. Therefore, the entirety of the £4.2m was taxable as employment income.

The Court also noted that the situation in this case was essentially on all fours with the decision in Eagles v Levy [1934] 19 TC 23. In that case, the taxpayer brought proceedings for unpaid remuneration from his former position as managing director of a company. The case settled on terms that he should receive an agreed sum of £45,000. Counsel for the company stated in court when announcing the terms of the settlement that the sum was *"a comprehensive sum; there are no costs on either side in the matter".* The taxpayer therefore had to pay his own costs out of the lump sum he received. Finlay J held that because the agreed sum did not represent or include costs, but (on the contrary) costs were deliberately excluded from it, the whole of the £45,000 represented remuneration for the taxpayer's services, and was taxable.

Comment

The case is a reminder that it is necessary to consider the true character of the payments under settlement agreements, as well as how they are described and who they are paid to, when determining their tax treatment.

Interestingly, it was agreed in this case that the payment of the agreed costs was not taxable on the grounds that the payment was of an amount over and above the amount that was paid to compensate the claimants for the unpaid overtime and allowances and was not a reward for services because it was for “something else” i.e. the costs incurred in the action against the Met. The Court of Appeal equally endorsed this point.

It seems to be important, therefore, that the payment of any costs or success fee should be separately identified and there is a separate obligation to pay such amounts, rather than simply being part of a global settlement sum. In fact, it is possible that HMRC would have accepted that the payment in respect of the success fee etc was not “earnings” from the outset had the settlement been structured to treat this as a separate amount in the same way as the agreed costs. On this issue, the Court of Appeal commented:

“Lest it be thought that this produces an unfair result because the question whether a payment is taxable or not depends on the structure of the settlement agreement and the label put on the payment, I would emphasise that the question whether a payment is taxable is a matter of substance, not form. If in substance the agreement involves an obligation on the part of the employer to make payment or reimbursement of costs or expenses which are unconnected with the payee's services as an employee, that element will not be taxable as "earnings". But in this case the parties chose to enter into an agreement by which only part of the settlement sum fell into that category, and the rest represented payments which, had they been made when it was alleged they fell due, would have been taxable as part of the employees' income.”

Current HMRC guidance at EIM32865 makes it clear that (in the context of ITEPA 2003 s.336) an employee’s legal costs are not deductible. This is on the basis of the decision in Eagles v Levy. It should also be noted that there is a specific statutory exception for payments in respect of legal costs incurred exclusively in connection with termination of an employee’s employment (though this is in the context of termination payments rather than earnings): see EIM13740.