Two recent cases give guidance on the tax treatment of settlement payments on termination of employment. A First-tier Tax Tribunal has, for the first time, laid down the correct approach to apportioning a settlement payment which is to compensate an employee for both discrimination and termination of employment. It was decided in Oti-Obihara v. HMRC that the proper starting point is the amount that can be identified as the ‘employment termination payment’, i.e. the amount which represents compensation for financial loss arising from the termination. The balance, being the compensation for injury to feelings, can be paid free of tax, recognising that it may be appropriate for a larger payment to be made.
In addition, the Court of Appeal in Norman v. Yellow Pages Sales Ltd has held that an employer has no implied duty to apportion a termination payment between taxable and non-taxable elements. The employer is entitled to deduct tax on the full amount (above £30,000), and any dispute over the amount of tax payable is a matter for the employee, not the employer, to pursue with HMRC.
Under sections 401 and 403 of the Income Tax (Earnings and Pensions) Act 2003 (‘ITEPA 2003’), a payment to an employee in connection with the termination of employment is chargeable to income tax, but the first £30,000 of such a payment is free of tax.
Where an employee has been successful in a discrimination claim, the Tribunal can award compensation for injury to feelings as well as for financial loss. Compensation for injury to feelings which is connected with the termination is taxable under section 401 ITEPA 2003. Compensation attributable to discrimination, which is not related to the dismissal, is tax free.
Apportioning a settlement payment in discrimination cases (Oti-Obihara v. HMRC)
What happened in this case?
Mr Oti-Obihara was employed at Morgan Stanley for just a year and a half. During his employment, he raised a grievance that he had been subjected to race discrimination and harassment. He brought a claim in the Employment Tribunal but reached a negotiated settlement of £500,000. Morgan Stanley paid this after deducting £103,400 in income tax (calculated on the basis that the £500,000, less the £30,000 exemption, was a taxable termination payment). Mr Oti-Obihara failed to declare the payment in his tax return on the assumption that most of the payment was for discrimination during employment and so was not taxable. HMRC disagreed and amended his tax return to apportion £28,000 of the settlement sum to compensation for discrimination/injury to feelings (which is tax free), with the balance as a payment in connection with the termination (taxable under section 401, in respect of the excess over £30,000).
The Tribunal found that HMRC had applied the wrong approach by calculating the amount attributable to compensation for injury to feelings first and then assuming the rest related to termination of employment. The correct approach should be first to determine the amount attributable to termination of employment, leaving the balance as injury to feelings (i.e. discrimination) which would be non taxable.
The question is how much should be attributable to termination of employment where discrimination is the cause of the termination? According to the case of Walker v. Adams (HM Inspector of Taxes) a compensation payment made on termination of employment for discrimination is taxable to the extent that it is compensation for financial loss suffered by reason of termination of employment. Any other compensation for discrimination arising during employment is not earnings so will not be taxable.
The Tribunal therefore looked at the evidence to ascertain whether the discrimination was related to the termination of employment. It recognised that, whilst there were factors suggesting otherwise (such as the fact that termination was not an issue until the later stages of the dispute), the employment was eventually terminated because Mr Oti-Obihara’s position became untenable due to the alleged discrimination and his feeling that his case had not been fully acknowledged in the grievance process. The Tribunal said if it were not for that, his employment would not have ended.
There was therefore a connection between the discrimination and the termination of employment. Therefore, as provided by Walker, the compensation on termination will be taxable to the extent it is compensation for financial loss suffered by reason of termination. It was therefore necessary to apportion the settlement sum between compensation for injury to feelings and compensation for financial loss arising out of termination (which the settlement agreement had failed to do).
The Tribunal’s guidance on how to calculate financial loss arising out of termination (taxable). To calculate the financial loss arising from termination, it is too narrow to look just at loss of basic salary over the 3 month notice period. This would have been just £18,000. Instead, it is reasonable to assume that the dismissal, brought about by discrimination, could result in Mr Oti-Obihara being out of comparable work for a longer period, particularly in the “market place” of City traders. In this case, the Tribunal thought 18 months’ loss would be reasonable and that salary, bonus and benefits in kind should be taken into account. This was estimated to be £165,000 – and was therefore taxable under section 401.
The balance, £335,000, was tax free as it represented the non-pecuniary loss resulting from discrimination. The Tribunal justified such a large sum by citing this case’s particular and untypical circumstances. It recognised that there was a likelihood of a US claim since Morgan Stanley was a US employer and Mr Oti-Obihara had worked for some time in New York. There was also evidence that Morgan Stanley was very concerned about confidentiality and protecting its reputation so had sought to settle this outside Courts (Mr Oti-Obihara’s manager mentioned offering $1 million to compensate alleged discrimination, before termination was an issue).
How the Tribunal justified such a large sum attributable to injury to feelings (tax free). The Tribunal said that HMRC’s original approach of ascertaining first the amount attributable to discrimination (with the balance being taxable as a termination payment) was incorrect. HMRC had arrived at a figure of just £28,000 for discrimination, relying on the guidelines laid down in the case of Vento v Chief Constable of West Yorkshire Police  EWCA Civ 1871 which provided that compensation for injury to feelings should not exceed £28,000, even in the most serious cases of discrimination. A greater amount was justified due to the particular circumstances of this case (as mentioned above) but also because the tariff in Vento is guidance in relation to awards by Tribunals only and not directly applicable to negotiated settlement agreements, and the Court in Vento made it clear that a particular case may warrant aggravated damages.
Employers are not obliged to apportion a termination settlement between taxable and non-taxable elements (Norman v. Yellow Pages Sales Ltd  EWCA Civ 1395)
What happened in this case?
Ms Norman had been employed by the Yellow Pages for about 6 months when she wrote to her employer claiming that they were in breach of her contract, which as a result had come to an end. Ms Norman then issued post-termination proceedings for direct sex and race discrimination, victimisation, wrongful dismissal and unlawful deduction of wages. A settlement was reached through ACAS and a settlement of ‘£53,000 . . .by way of compensation’ was recorded in a standard COT3 form. Yellow Pages paid Ms Norman £47,657, having deducted tax and NICs from the amount above the £30,000 tax-free threshold.
Ms Norman issued County Court proceedings, claiming that the agreement required payment of £53,000, that there was an implied obligation on the employer to apportion the payment between taxable and non-taxable elements and that any tax on that sum was payable by Yellow Pages over and above that sum. This point was dismissed and appealed right up to the Court of Appeal. The Court, in turn, rejected the claim that Yellow Pages was under any implied obligation to make a fair apportionment within the sum of £53,000 between injury to feelings (tax free) and financial loss (taxable). In rejecting Ms Norman’s arguments, the Court said that there was no good reason to imply an obligation on an employer to make an apportionment. Indeed, the Court said that the opposite is, in fact, the case because:
- there was no evidence to suggest that any question of apportionment was raised during negotiations;
- if there was an obligation to recognise injury to feelings in order to apportion the settlement sum, then settlement, in many cases, would be impossible;
- the employer owes a duty to HMRC and will want to avoid any suggestion that they are avoiding the payment of tax due; and
- HMRC is, in any event, not obliged to accept an apportionment agreed by the parties.
It was further commented that ‘if a compromise is agreed and it does not itself apportion its award between taxable and non-taxable elements, it is for the employee, not the employer, who pays the tax on the employee’s behalf, to sort out the position with Revenue and Customs’.
What do these cases mean for employers?
There is therefore no obligation on employers to apportion a settlement sum between taxable and non-taxable elements. However, employers may, in some cases of discrimination, wish to do this since the larger the amount attributable to injury to feelings (which is tax free), the better for the employee, and the lower tax liability may prove particularly persuasive to the employee to agree to the settlement. The downside to employers is that they owe a duty to HMRC to account correctly under PAYE for tax due and will be reluctant to invite any allegations that they are breaching this duty by avoiding paying tax.
Even if an apportionment between taxable and non-taxable elements is agreed, HMRC is not bound by a negotiated apportionment. The decision in Oti-Obihara illustrates that even where there are elements of the claim which may be unrelated to the termination itself, when it is clear that the employer/employee relationship became unsustainable as a result of the discrimination, it is difficult to show that the two are unrelated. Nevertheless, on the special facts of Oti-Obihara, the Tribunal was prepared to attribute a far higher amount to injury to feelings than may have been previously thought possible, so this may lead to employees to push for apportionment of a more significant element to injury to feelings. Employers should be wary though, as a challenge by HMRC to any agreed apportionment could result in open litigation which could lead to unwanted publicity of the settlement amount and surrounding circumstances. Employers should ensure that tax liability is settled with HMRC to avoid any future dispute which would be detrimental to their reputation.
Usefully for employers, Oti-Obihara also highlighted that when determining the ‘employment termination payment’ they can take into account the fact that the employee may not be able to find equivalent employment for a period beyond their notice period.