HR practitioners will be familiar with the principle set out in section 401 of the Income Tax Earnings and Pensions Act 2003 (ITEPA) that any part of a payment received in consideration, consequence or in connection with the termination of employment which is not otherwise chargeable to tax will nonetheless be taxable, although the first £30,000 of such a payment will be free of income tax by virtue of section 403 ITEPA. However, the position in respect of payments of compensation relating to injury to feelings for discrimination has always been slightly confused.
HMRC and the First Tier Tax Tribunal have taken the view that if the discrimination is found to occur before termination of employment any compensation attributable to that (including for injury to feelings) will be wholly exempt from tax. If, on the other hand, the injury to feelings arises out of the termination of employment, HMRC takes the view that the award will be taxable under section 401 ITEPA.
Section 406 ITEPA provides that payments made “on account of injury to, or disability of, an employee” are exempt from tax without limit. The EAT’s view is that injury to feelings awards are tax free on the basis that it is “injury” within the meaning of s.406 ITEPA. The EAT has not made the distinction between discrimination occurring before termination and discrimination arising out of the termination of employment.
So there has been a conflict between HMRC’s and the First Tier Tax Tribunal’s view on this matter against the view of the EAT. Ultimately, it is a matter for the tax authorities, rather than the EAT, whether an award for injury to feelings is taxable. The Upper Tribunal (Tax and Chancery Chamber) has clarified matters in Moorthy v HMRC rejecting the approach taken by both the First Tier Tax Tribunal and the EAT holding that:
1) any payment or other benefit which is received “directly or indirectly in consideration or in consequence of, or otherwise in connection with” the termination of a person’s employment is taxable by virtue of section 401 ITEPA, subject to the section 403 £30,000 exemption; even if the payment or other benefit was made in settlement of a discrimination claim, for unfair dismissal, or for other reasons; and
2) damages for injury to feelings are not to be classified as payments or other benefits “on account of injury to, or disability of, an employee” within section 406 ITEPA.
In practice therefore employers should be mindful that employees may now seek higher compensation in settlement of discrimination claims and / or an indemnity in respect of any claim for tax from HMRC relating to any compensation payment for injury to feelings. If you would like to discuss this further please do not hesitate to contact me or one of the team.