A payment for injury to feelings that is paid in connection with termination of employment is taxable. This is contrary to the established view of the Employment Appeal Tribunal (EAT). Our tax and employment specialists look at the current state of play in this evolving and often contradictory area of law.
In Moorthy v The Commissioners for HM Revenue and Customs, the Upper Tribunal ruled that injury to feelings payments made in connection with the termination of employment are taxable. The income tax exemption under s.406 ITEPA does not apply because injury to feeling is not an "injury" for these purposes.
In the Moorthy case, the Tax and Chancery Chamber of the Upper Tribunal (Upper Tribunal) confirmed that compensation for injury to feelings resulting from discrimination on termination of employment is liable to income tax.
The employee was made redundant. He brought proceedings in the employment tribunal claiming unfair dismissal and age discrimination (note there was no discrimination prior to termination). The claim was settled and the employee was compensated with an ex gratia sum of £200,000 "by way of compensation for loss of office and employment". There was no separation of the settlement amount to different heads of claim.
The employer paid the first £30,000 tax free and taxed the rest of the payment.
The employee claimed that the whole sum was tax free but HMRC determined that the sum was taxable (to the extent it exceeded £30,000). The employee appealed to the First Tier (tax) Tribunal (FTT). The FTT dismissed the appeal.
The employee subsequently appealed to the Upper Tribunal, where he argued that the settlement payment was not taxable because:
- it was not a payment in connection to termination under section 401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA); and
- injury to feelings compensation came under the exemption to income tax under section 406 ITEPA as a payment or benefit "on account of injury to... an employee".
The argument that the compensation came under section 406 had not been made by the employee in the FTT. However, the Upper Tribunal allowed this argument as they saw the case as an opportunity to provide guidance on the meaning of 'injury' for the purposes of section 406 (as this issue had not previously been considered by the Upper Tribunal).
The Upper Tribunal also dismissed the appeal and ruled that the compensation was taxable under section 401 ITEPA (to the extent it was over £30,000) because:
- there is nothing to prevent non-pecuniary payments, such as damages, from being within the scope of the tax charge; and
- it did not fall within the exception at section 406 as injury to feeling is not an "injury" for the purposes of the tax exemption under section 406. It applied the judgment in the leading case of Horner v Hasted (Inspector of Taxes)  STC 766, which stated that injury for these purposes must be a medical condition. Injury to feelings alone is not enough.
Consequently, injury to feelings damages are potentially taxable if they are connected in any way with the termination of employment.
This approach differs from the decisions made by the EAT in the cases of Orthet Ltd v Vince-Cain  I.C.R. 374 and Timothy James Consulting Ltd v Wilton  ICR 764. In those cases it was decided that the payment for injury to feelings came under the section 406 exemption and was tax free. The Upper Tribunal in Moorthy stated that these cases had been wrongly decided on that point.
By contrast, the Upper Tribunal acknowledged that if the compensation is paid in respect of discrimination during employment (unrelated to the termination), it is not taxable under section 401.
Any payment made for injury to feeling, even if made in respect of discrimination during employment, is likely to be open to challenge if it exceeds the usual "Vento" bands for the level of awards of this kind. (In Vento v Chief Constable of West Yorkshire Police  EWCA Civ 1871, the Court of Appeal issued guidance on the assessment of damages in discrimination cases). So, parties cannot allocate an excessive payment to "injury to feeling" during the course of employment in an attempt to avoid tax.
What happens now?
The Upper Tribunal decision in Moorthy is binding on the FTT but not on the EAT. That means the law now has conflicting views on the treatment of injury to feelings under section 406. However, we expect HMRC to follow the interpretation of the Upper Tribunal. Essentially, the tax treatment of compensation for injury to feeling depends on whether the discrimination is in connection with the termination.
If employers incorrectly make a tax free payment, in practice, it is likely that HMRC will seek to recover any under deducted tax from the employer rather than the employee, so it is important to tax any payments correctly. There is usually an indemnity clause in a settlement agreement dealing with any claims for extra tax on the settlement sum but that should be seen as a fall-back position and it is preferable to deduct tax correctly at the outset.
When making a payment to a departing employee for injury to feelings, it is important to keep a good written record of whether the injury arose in the course of the employment or in connection with the termination. However, in practice, it may be difficult to distinguish the injury to feelings award from the termination.
If the employer and employee are entering into a settlement agreement, the agreement should carefully state when the injury to feelings took place.
While any payments for injury to feeling clearly arising during the employment will still be exempt from tax, if it occurred in relation to both the employment and the termination, the agreement should apportion the payment appropriately.
If, however, the discrimination arose in connection with the termination, it is advisable for employers to treat this element of the payment as taxable (to the extent the total settlement figure exceeds £30,000). As a result, in these cases, employees are likely to ask for the payment to be grossed up to account for the tax, increasing the overall settlement sum.
Given the conflicting decisions in this area, there is a strong possibility that this decision will go before the Court of Appeal and the position on the treatment of injury to feelings will be clarified further. We watch with interest.