tax_returnIn the absence of a codified system of law (such as that which operates in France) there is a risk that conflicts can arise between different jurisdictions and courts. For example, an insolvency court might make an order concerning property while a family court (applying its different rules) may make a conflicting order in respect of the same property. Which one prevails?

Another example is whether someone is an employee for tax purposes and for employment law purposes. It is possible to be an employee in one sense and not the other.

Another area of contention is whether compensation is taxable. The generally accepted view is that compensation for injury constitutes damages and as such should be tax free. However, compensation for financial losses, e.g. loss of earnings, should be taxable subject to the usual allowances and exemptions. In Moorthy v Commissioners for HM Revenue and Customs the Tax and Chancery Chamber of the Upper (Tax) Tribunal considered whether compensation for injury to feelings should be taxable.

Mr Moorthy worked for Jacobs Engineering (UK) Limited. In March 2010 he was made redundant and received a statutory redundancy payment of £10,640. He brought proceedings claiming unfair dismissal and discrimination. Following mediation he entered into a settlement agreement which provided for him to receive an “ex gratia payment of £200,000 by way of compensation for loss of office and employment”. Jacobs treated the first £30,000 as free of tax applying the usual exemption (section 403 Income Tax (Earnings and Pensions) Act 2003). Basic rate income tax was deducted from the remainder. Mr Moorthy completed his 2010-11 tax return on the basis that the full settlement amount was tax free. HMRC disagreed and amended the return to include an additional £140,023 taxable income. The issues on appeal were (1) whether the settlement payment was in connection with the termination of employment and was therefore chargeable to income tax (subject to the £30,000 exemption) (section 401); (2) if so, was it taken out of the charge to tax as a payment or benefit “on account of injury to…an employee”, namely injury to feelings (section 406); and (3) whether Mr Moorthy could rely on the concession made by HMRC in the closure notice that £30,000 of the settlement amount should be treated as damages for age discrimination and therefore not chargeable to income tax.

The decisions of Mrs Justice Rose and Judge Sinfield were:

  1. The payment was in connection with the termination of employment and was therefore chargeable to income tax.
  2. “Injury” as referred to in section 406 does not include injury to feelings.
  3. Mr Moorthy could not rely on the concession by HMRC concerning treating £30,000 of the settlement as damages.

The result was that the appeal was entirely unsuccessful.

The most interesting part of the judgment is the exclusion of injury to feelings from the definition of “injury”. It was acknowledged that different court and tribunals have reached different conclusions when considering the matter. For example, in the case of Orthet the Employment Appeal Tribunal held that awards for injury to feelings in discrimination claims, whether arising from termination of employment or otherwise, were not taxable. A similar approach was adopted in the EAT case of Timothy James Consulting Ltd v Wilton. In this case it was held that the reasoning applied in both cases was flawed. For the purposes of section 406 “injury” should be considered “as meaning a medical condition that results in the termination of employment or a change in duties or earnings related to the employment. On that interpretation, injury to feelings would not come within section 406”.

The rationale appears to me to be based on a very narrow and rigid analysis (as might be expected in a tax tribunal) and, as such, it is broadly unconvincing. Nonetheless, as it stands, this decision stands as authority for the proposition that such payments are liable to tax. It exposes another unsatisfactory aspect of employment and tax law in that, if the courts cannot make up their minds, how is it reasonable for employers to be expected to know how to treat such payments.

Another interesting aspect for consideration is whether the tax treatment would or should have been different if it related to an award made by the Tribunal at the end of the hearing. If so, it could be seen as a disincentive to settlement.