Tax On Termination Payments

A tricky question regarding the tax treatment of different types of termination payments has been considered recently by the Upper Tribunal.

Employees who have suffered discrimination either during employment or on termination can seek compensation for loss of employment. Many also seek compensation for injury to their feelings. A recent tax Tribunal case has addressed how and when such payments may be taxable.

The default position is that payments related to the termination of employment will be taxable. However, the first £30,000 of such a payment is generally free of income tax provided that it is not something to which the employee was contractually entitled. Any excess compensation over £30,000 is taxable, unless it falls within a category of specific exemptions.

One such category of exemption includes payments made in connection with the termination of employment by reason of the employee's death, disability or injury. In an employment law case (not a tax case), the Court of Appeal decided that "injury" could also include injury to feelings, a type of compensation awarded to employees to compensate them for the hurt to their feelings due to the discrimination that they have endured.

The latest case from the Upper Tribunal (Tax) draws a distinction between discrimination during employment (in which case a payment for injury to feelings can potentially be made tax free) and discrimination in connection with the termination of employment (in which case a payment for injury to feelings will be taxable unless there is an identified medical condition in respect of which the payment is made).

Facts

Mr Moorthy was the Executive Director of Operations at Jacobs Engineering (UK) Ltd, earning £111,000 per year. Mr Moorthy's employer decided they needed fewer senior managers and senior staff were told to apply for the remaining jobs. Mr Moorthy failed to secure one of the new posts.

He was put on gardening leave for his entire notice period and was then paid his statutory redundancy pay of £10,640, without deductions for tax. Mr Moorthy brought claims in an Employment Tribunal for unfair dismissal and alleged that he was selected for redundancy or dismissed because of his age.

The parties engaged in a mediation process and Jacobs Engineering decided to settle Mr Moorthy's claims. He received an ex-gratia sum of £200,000 and tax was deducted to the extent the payment exceeded £30,000. When he submitted his tax return to HMRC, he explained that he...