Most settlement agreements will have an indemnity in favour of the employer allowing it to pass the liability back down to the employee. However, this is unattractive as recovery from an ex-employee can be difficult.
Both the employer and former employee will want the termination payment to be legitimately structured to reduce the tax liability and will also want certainty that no future tax liability will arise. Broadly speaking a termination payment is taxable under the Income Tax (Earnings and Pensions Act) 2003 (ITEPA) other than in respect of the first £30,000 which is specifically exempted by section 403.
Oti-Obihara v HMRC  UKFTT 568(TC) held that where discrimination is the cause of the termination, a compensation payment is only taxable to the extent that it meets any financial loss caused by the termination. So far as the payment relates to injury to feelings then it can be paid tax free.
This has led to some employers structuring termination payments in discrimination cases by allocating a tax free sum to ‘injury to feelings’.
This matter was recently considered by the case of Moorthy v the Commissioners for Her Majesty’s Revenue & Customs.
M was made redundant and was subsequently given £200,000 under the terms of a settlement agreement. M argued that none of the £200,000 was taxable because it had been paid to settle a discrimination claim, to compensate him for not being selected for an alternative job.
HM Revenue & Customs contended that the £200,000 was taxable as a termination payment ITEPA other than:
- in respect of the first £30,000 which was specifically exempted under ITEPA s 403 and
- a further £30,000 representing compensation for injury to feelings (this being the sum that was generally regarded as the maximum award for injury to feelings following tribunal guidelines).
On appeal the First Tier Tribunal held that the payment of £200,000 fell within ITEPA. It rejected HMRC’s stance that injury to feelings awards are not taxable holding that any payment made "directly or indirectly in consideration or in consequence of, or otherwise in connection with" the termination of employment was taxable except for the usual exemption of the first £30,000.
This is intended for general information only and should not be considered as giving advice in relation to any individual case nor be taken as applying to any particular case. No liability is accepted for any such use of the information contained.