Taxation of restrictive undertakings and settlement payments

The FTT has held that payments for a restrictive undertaking in connection with an employment are taxable whether or not the undertaking restricts the conduct of or activities in connection with any employment: Mrs A v HMRC [2022] UKFTT 421. As such, payments made in a settlement agreement in connection with confidentiality and non-disclosure undertakings and in relation to dropping Employment Tribunal claims were subject to tax as employment income in full.

In the alternative, those payments were made in connection with the termination of the taxpayer’s employment. Arguments by the taxpayer that th payments were not in connection with the termination were fatally undermined by express terms of the settlement agreement to the contrary.

Background

Mrs A was employed by her employer as a Head of Retail. In 2017, however, she commenced grievance procedures alleging sexual harassment, bullying, victimisation and intimidation by the owner of her employer. An internal enquiry was carried out through her employer’s grievance procedure, but this did not uphold her claim. Mrs A was very dissatisfied with the employer’s internal grievance process and its conclusion and subsequently, began proceedings in the Employment Tribunal against the employer and the owner.

Although originally she intended to continue in her role, Mrs A claimed to have come under a great deal of pressure to drop her claim. Eventually, she decided to leave her employment and, following further negotiations, she then agreed to settle her claim.

A settlement agreement was drawn up by the employer which agreed to pay Mrs A the following sums

• £45,000 (the Tribunal Claim Compensation Sum) as compensation for injury to feelings and aggravated damages in full and final settlement of the Tribunal Claim;
• £1,055,000 (the Compensation Sum) as compensation for the termination of Mrs A’s employment and any and all claims she had or may have had against the employer or the owner, subject to the undertakings of confidentiality and non-disclosure in relation to the allegations and the Employment Tribunal claim.

The employer deducted PAYE on payment of the Compensation Sum and Mrs A made a claim to HMRC for repayment, which HMRC rejected. HMRC accepted that the Tribunal Claim Compensation Sum was paid for injury to feelings and aggravated damages as a result of the alleged conduct which led to the grievance procedure and Employment Tribunal proceedings. HMRC also accept that the conduct was not connected to the termination of Mrs A’s employment and was correctly paid without deduction of tax

FTT decision

Mrs A contended that the Compensation Sum was, in reality, paid for her silence and for dropping the Employment Tribunal claim. Mrs A’s evidence was that she left her job voluntarily and was paid a sum to prevent her discussing her departure and the events leading up to it. The Compensation Sum was not paid to compensate Mrs A for anything relating to her contract of employment or for its termination, but was wholly related to the confidentiality and non-disclosure obligations in the Settlement.

The FTT noted, therefore, that the question whether the Compensation Sum was taxable was a two-stage question. Firstly, was it taxable as a payment for a restrictive undertaking under ITEPA 2007 s.225. If not, was it nevertheless taxable under s.401 as a payment on termination of employment.

Restrictive undertakings

ITEPA 2007 s.225 provides where an individual gives a restrictive undertaking in connection with the individual’s current, future or past employment, a payment made in respect of that undertaking is treated as earnings from the employment. Section 225(8) defines a restrictive undertaking as “an undertaking which restricts the individual’s conduct or activities”.

In this case, it was clear that Mrs A had entered into restrictive undertakings in the Settlement, such as restricting her from divulging the details of her complaints and requiring her to drop her Employment Tribunal claim. However, she argued that the meaning of “restrictive undertaking” in the context of s.225 referred only to a restrictive undertaking that operated in the course of her current, past or future employment. And that was not the case here.

The FTT rejected this argument. Section 225(1) does not qualify the definition of ‘restrictive undertaking’. As such, those provisions must be read as providing that an undertaking which restricts an individual’s conduct or activities, whether related to their employment or personal lives, which is given in connection with their current, future or past employment falls within s.225. The FTT rejected the argument that a restrictive undertaking must relate to the individual’s conduct or activities in the course of their employment in order for it to fall within s.225. Any undertaking which restricts the individual’s conduct or activities and is given in connection with their employment is within the scope of the section.

As such, to the extent the Compensation Payment was made in return for the giving of restrictive undertakings (as contended by Mrs A), it was subject to tax as employment income.

Termination payment

In case the FTT was wrong on the first argument, it went on to consider whether the payment would be taxable (were it not otherwise taxable as earnings) as a termination payment. Section 401 taxes any “payments and other benefits which are received directly or indirectly in consideration or in consequence of, or otherwise in connection with the termination of a person’s employment”.

HMRC contended that the Compensation Sum was, at the very least, paid otherwise in connection with the termination of Mrs A’s employment, and the FTT agreed with HMRC that the phrase “otherwise in connection with” set out in s.401(1) is extremely wide in scope. Moreover, the Settlement itself stated that the Compensation Sum was paid as compensation for the termination and there was no evidence to suggest that the position in the Settlement was inconsistent with reality.

The Tribunal accepted that the Compensation Sum was a payment that had more than one purpose. It was in part consideration for Mrs A’s undertaking not to say anything about the grievance and the Employment Tribunal proceedings. However, that additional purpose or effect did not mean that there was no connection with the termination of her employment. Indeed, the contractual position was clear from the words of the Settlement Agreement and, looking at all the evidence in the round, there was a connection between the payment of the Compensation Sum and the termination of Mrs A’s employment.

As such, even if the Compensation Sum had not been taxable as employment income under s.225, it would have been taxable under s.401 (subject to a £30,000 exemption).

Finally, the FTT considered whether the Compensation Sum could be apportioned between elements that relate to the termination of Mrs A’s employment and other elements. However, since the Settlement Agreement already provided for apportionment between the Tribunal Claim Compensation Sum and the Compensation Sum that was not possible in this case. The Compensation Sum was a single, undivided amount. The Settlement Agreement did not provide for any further apportionment of the Compensation Sum and there was no evidence on which such an apportionment could be made.

Comment

The FTT’s decision is an important reminder that the terms of a settlement agreement must be considered carefully by both parties. The starting point for analysing the nature of the payments is the contractual terms, and whilst HMRC will not be bound in all circumstances by these terms, they are likely to have great importance in determining what a payment is made for.

The fact, in this case, that the Settlement itself clearly stated that the payment was made in connection with the termination of the employment meant that the taxpayer always faced an uphill struggle to overcome that analysis. Indeed, in attempting to dislodge that analysis, the taxpayer appears to have made the situation worse in bringing the whole of the payment within the scope of employment income by reference to the restrictive undertakings given in the Settlement.

Ideally tax advice should be taken when entering into any such settlement. In the absence of express provision, taxpayers seeking to allocate parts of a single sum to separate elements are likely to meet resistance from HMRC.