Injury to Feelings Compensation Taxable as a Termination Payment

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.

Speedread

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. There is nothing in the legislation which excludes compensation for injury to feelings from the scope of the tax rules on termination payments. Once a connection is established between a payment and the termination of employment, it falls to be taxed as a termination payment. 

Facts

In Moorthy v The Commissioners for Her Majesty’s Revenue & Customs, M was made redundant. He 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 agreement provided that the first £30,000 would be paid without deduction of income tax and the balance would be taxed. 

When completing his tax return, 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 and the First-tier Tax Tribunal disagreed. M appealed to the Upper Tier Tax Tribunal. 

Decision

The Upper Tier Tax Tribunal rejected M’s appeal. The whole £200,000 payment fell to be taxed as a termination payment under s401 Income Tax (Earnings and Pensions) Act 2003 (ITEPA). There is nothing in the legislation which excludes compensation for injury to feelings from the scope of the tax rules on termination payments. Once a connection is established between a payment and the termination of employment, it falls to be taxed as a termination payment. 

In addition, injury to feelings payments do not fall within the tax exemption in s406 ITEPA for payments made on termination “on account of injury to…..an employee”. “Injury” for these purposes means a medical condition that results in the termination of employment and therefore injury to feelings payments are not covered.

Implications

The tax treatment of a payment for injury to feelings will differ depending on whether it is intended to be compensation for an act of discrimination which occurred during employment or alternatively on termination. Where the payment relates to termination of employment, it is taxable as a termination payment (and the first £30,000 of the overall compensation paid in connection with termination can be paid tax free). However, where compensation is paid for injury to feelings in respect of acts of discrimination occurring during employment, it is not taxable at all.

When drawing up settlement agreements, employers need to give careful consideration to the tax treatment of the different elements of the compensation payment. Where acts of discrimination occur both during employment (unrelated to termination) and on termination, injury to feelings payments should be separated out and their tax treatment specified separately.

The tax exemption for payments made on termination “on account of injury to…..an employee” is construed narrowly by HMRC and does not cover injury to feelings payments made on termination.