Injury to feelings compensation for a redundancy tainted by age discrimination should have been taxed

A tax tribunal has ruled that a payment for injury to feelings made to an employee who claimed he was selected for redundancy because of his age was taxable as a termination payment. 

In Moorthy v The Commissioners for Her Majesty’s Revenue & Customs, M was made redundant in March 2010 and was paid an enhanced redundancy payment of £10,640 which was paid in the 2009/10 tax year. 

M claimed that he had been selected for redundancy because of his age and brought claims of age discrimination and unfair dismissal, seeking compensation for loss of earnings and injury to feelings. Following a successful mediation, his employers agreed to pay him £200,000 under a settlement agreement. The sum was surprisingly not broken down and no particular element was attributed to injury to feelings. The agreement provided that the first £30,000 would be paid without deduction of income tax and the balance would be taxed at 20%. Payment was made in the 2010/11 tax year.

When completing his tax return for the 2010/11 tax year, M argued (rather ambitiously) that the whole of the settlement sum should have been paid tax free and sought to reclaim the £34,000 tax deducted. HMRC disagreed and the dispute eventually came before the First-tier Tribunal (tax). 

The judge ruled that the whole £200,000 payment fell to be taxed as a termination payment under s401 Income Tax (Earnings and Pensions) Act 2003 because it was made in connection with the termination of M’s employment. It rejected M’s argument that the payment had been made in respect of events leading up to his dismissal, rather than the dismissal itself. 

The first £30,000 could therefore be paid without deduction of tax and the balance was taxable. However, as M had already used up part of the £30,000 tax fee slice when he received his redundancy payment in the previous tax year, only £19,360 should have been paid without deduction of income tax. 

Although the result in this case accords with the generally accepted view, the question of whether an injury to feelings award paid in respect of a discriminatory dismissal can be paid without deduction of income tax has been the subject of some confusion as a result of unclear case law. The tax tribunal in this case considered that none of the case law authorities relied on by M established that payments for injury to feelings were not taxable if made in connection with the termination of employment. In so far as any of the authorities suggested otherwise, those cases were wrongly decided.

The position therefore is now clear. Where an injury to feelings payment relates to termination of employment, it is taxable under s401 ITEPA. However, where compensation is paid for injury to feelings in respect of acts of discrimination occurring during employment, it is not taxable.

When drawing up settlement agreements, employers need to give careful consideration to the tax treatment of the different elements of the compensation payment. The payment should be broken down into the various elements. Where acts of discrimination occurred both during employment (unrelated to termination) and on termination, injury to feelings payments should be separated out and their tax treatment specified separately. Payments for discriminatory acts unrelated to termination can be paid without deducting tax but any payments in respect of acts connected with the dismissal will need to be taxed under the rules relating to termination payments.

This case also reminds employers that an employee is only entitled to one £30,000 tax free slice in respect of the termination of their employment, even if payments are made in different tax years.