Injury to feelings awards likely to be taxable

The case of Moorthy v Commisioners for HMRC concerned the taxation of monies paid under a Settlement Agreement. Following mediation after the Claimant was made redundant he was paid an ex gratia sum of £200,000 as compensation of loss of office and employment. The first £30,000 was exempt from tax under section 403 Income Tax (Earnings and Pensions) Act (ITEPA) but income tax was deducted at the basic rate from the balance of £170,000. When Mr Moorthy completed his tax return he operated on the basis that the entire amount should be tax-free. He sought to reclaim the amount of tax which had been paid on the balance over £30,000. He challenged the closure notice issued by HMRC; but the First Tier Tribunal found that the entirety of the settlement sum had been paid in connection with the termination of his employment, and as such fell under section 401 ITEPA. It was therefore chargeable to tax in accordance with section 403 (allowing the £30,000 exemption to tax but no more). Mr Moorthy appealed that decision to the Upper Tribunal, arguing that the payment should have been assessed for tax under section 406(b) ITEPA which exempts from tax any payments made on account of “injury” to an employee.

He lost. The Upper Tribunal agreed with the First Tier Tribunal that the whole amount had been paid in connection with the loss of his employment and as such fell within the ambit of section 401. It held that this section applied to payments made even where the termination was fair and lawful and includes non-pecuniary matters such as damages for injury to feelings. With regard to the section 406 exemption the Tribunal did not accept that any of the amounts paid were on account of “injury”. It held that the use of this word in the section was very specific and it was intended to apply to injury to feelings which led to the termination of employment or to a change in duties or level of earnings, not the termination itself.

In the light of this decision, it is going to be far more difficult to successfully argue that awards for injury to feelings may be paid free of tax under section 406. Only if they are genuinely referable to a discrimination giving rise to an injury to feelings award which is completely, or virtually, unconnected to a dismissal, will it be possible to do this. Furthermore, the Upper Tribunal took the view that the use of the word “injury” in section 406 refers to a medical condition and does not include injury to feelings.

Structuring Settlement Agreements going forward will have to be undertaken very carefully if the intention is to try and claim amounts in addition to the £30,000 exemption as tax-free.

For further details on any of the issues covered in this update please contact Gemma Ospedale, Partner in Employment on 020 7583 2222.