Termination payments and discrimination

The Court of Appeal has held that a payment in relation to a claim for unfair dismissal and age discrimination did, in part, fall within the exemption from tax for payments on account of “injury”: Moorthy v HMRC [2018] EWCA 847. Whilst the payment in this case was clearly connected with the termination of the employment (and so in principle taxable under section 401), the court considered that the natural meaning of “injury” was wide enough to cover “injury to feelings”, at least in the context of an age discrimination claim.

It should be noted, however, that Finance (No 2) Act 2017 has since introduced an amendment to the exemption in section 406 to limit its scope from April 2018 to “psychiatric injury” but excluding “injury to feelings”.

Background

Mr Moorthy was a senior employee at Jacobs Engineering. In 2009, he was informed that there would be a restructuring of senior roles and, following a selection process in which Mr Moorthy was unsuccessful, he was told he would be dismissed by reason of redundancy. In March 2010, following a period of 12 months gardening leave, his employment was terminated. Shortly after that time, he received statutory redundancy pay of £10,640 from which no tax was deducted.

Mr Moorthy commenced proceedings at the Employment Appeal Tribunal (EAT), alleging unfair dismissal and age discrimination. However, following mediation, he entered into a compromise agreement with his former employer, under which, he received "an ex gratia sum of £200,000 by way of compensation for loss of office and employment". The payment was in full and final settlement of his claims, made without any admission of liability and contained no allocation of sums.

Mr Moorthy received £30,000 tax free and the remainder of the payment was made subject to deduction of tax at 20%. In 2012, however, he claimed a repayment of tax from HM Revenue & Customs (HMRC), contending that the payment was for injury to his feelings and not taxable under ITEPA 2003 section 401. HMRC rejected the reclaim and Mr Moorthy appealed to the First-tier Tribunal (FTT). The FTT dismissed his appeal, holding that the settlement payment fell within section 401. The Upper Tribunal upheld that decision.

Decision of the Court of Appeal

The Court of Appeal noted that two issues were before them:

• firstly, did the payment fall within ITEPA 2003 section 401 as a payment in connection with termination of employment, and
• secondly, was the payment excluded from tax by ITEPA 2003 section 406 which provides for an exception for a payment made “on account of injury to, or disability of, an employee”.

Did the payment fall within section 401?

The Court of Appeal considered that it was “clear beyond reasonable doubt” that the entirety of the payment fell within section 401. On any natural reading of the statutory language, the payment was received “directly or indirectly in consideration or in consequence of, or otherwise in connection with” the termination of Mr Moorthy’s employment. Indeed, the payment was described in the compromise agreement as representing compensation for loss of office and employment.

Did the payment fall within section 406?

In relation to the construction of section 406, the Court of Appeal considered that a payment for damages for injury to feelings in the context of an age discrimination claim would fall within the natural language of section 406. There is no definition of “injury”, but there was no indication in the statutory language to limit it to any particular type of injury. The court noted that the concept of “injury” to an employee is a good example of the “always speaking” approach to statutory language because medical science does not stand still and Parliament cannot have intended that the scope of the exemption would always be construed by reference to the state of medical knowledge when it was enacted in 1960. In normal language, we speak of “injury to feelings” and, therefore, as a matter of ordinary language the injury to his feelings suffered by Mr Moorthy was nevertheless an “injury”.

Moreover, the court noted that had damages been awarded in respect of injury to feelings in a situation outside the scope of section 401, then those damages would not have been subject to income tax at all.

Accordingly, the court concluded that the termination payment, to the extent it represented a payment for injury to feelings, fell within the exception in section 406. In addition, the court considered that just as an award of damages for injury to feelings made by an employment tribunal to a claimant for age discrimination would fall within section 406, the same must apply to the appropriate portion of a sum paid by an employer in settlement of such a claim, even if (as usually will be the case) the payment is made without any admission of liability. However, the court also noted that the Vento guidelines show that such awards of damages must be relatively modest in amount. As such, in this case, it was accepted that the part of the payment allocated to “injury to feelings” should not exceed £30,000.

The court also stressed that it expressed no view on the question “whether the exemption might also in principle apply to payments made in respect of injury to feelings where no statutory basis [such as age discrimination] for such a claim could exist”. (Albeit that the question in practice may not arise due to the restriction to the scope of the exception introduced in 2018.)

Comment

The Court of Appeal’s decision that the payment in this case in respect of alleged discrimination was made in connection with a termination of employment and so was taxable under section 401 is unsurprising. In this case, the discrimination was closely tied to the act of termination itself, so that it was inevitably connected with the termination and taxable as a termination payment. In this context, HMRC’s guidance in EIM12965 suggests where part of a settlement payment can be reasonably attributed to discrimination occurring before termination, they will accept that it is not employment income as it is not “connected” with the termination.