Dear hrlaw auntie

I work in the Human Resources department of a medium sized manufacturing organisation, and am a little confused by a letter we have recently received from the Inland Revenue. It claims that a payment of under £30,000 that we made to an employee in order to settle his unfair dismissal complaint is properly chargeable to tax and does not fall within the exemption set out in section 403 of the Income Tax (Earnings and Pensions) Act 2003.

The payment to the individual arose from a negotiated compromise of a dispute about the termination of his employment. We had attempted to change this individual’s terms and conditions of employment and when he did not agree we terminated his contract and immediately re-employed him on the new terms and conditions. He sued us successfully for unfair dismissal.

We settled his complaint prior to the remedy hearing and offered him reinstatement on his old terms and conditions. The employment tribunal made an order giving effect to the terms of the agreement we had reached, describing the settlement payment as a “basic award”. The Inland Revenue say that had the remedies hearing gone ahead the tribunal would not have had the jurisdiction to order a basic award and reinstatement and therefore the payment must be referable to the individual’s employment and is therefore taxable. Are they right?

Yours

Irritated by the Inland Revenue

 

Dear Irritated

I can see why the Inland Revenue want to tax the payment you have described, but the Court of Appeal in the recent case of Wilson (HM Inspector of Taxes) v Clayton, held that where a payment is received ‘in connection with’ the termination of employment, it is not taxable as to the first £30,000. The fact that the tribunal has no jurisdiction to make an order for a basic award as well as an order for reinstatement, is irrelevant to the question of whether the payment should be taxed.

In Wilson v Clayton the Inland Revenue argued that the payment to Mr Clayton was chargeable to tax either as a ‘payment for services’ or as a ‘benefit’. To be brought into charge as a ‘payment for services’ there must be some causal link between the payment made and the services rendered, whether past or future. It does not sound to me as though the payment you have described was made to this individual in return or as reward for past services, or as an inducement to enter into employment, or to provide future services: it was compensation for unfair dismissal and was paid ‘in connection with’ the termination of his employment, not ‘as a result of’ the employment. It ought therefore to be capable of falling within the £30,000 tax exemption set out in the Income Tax (Earnings and Pensions) Act 2003.

You should also be able to show that the payment is not taxable as a ‘benefit’. In Wilson v Clayton, the fact that Mr Clayton did better than he would have done at a contested remedy hearing made no difference unless it could be shown that the payment to him was purely gratuitous. The Court of Appeal said that it would be a difficult task for any tribunal or court to unpick the constituent parts of the bargain reached between the parties and to put a value on those parts to determine whether the reason for payment was to confer a gratuitous benefit within a compromise agreement which would then be properly chargeable to tax. In the situation you have described, the company has been sued successfully for unfair dismissal and it is obvious that the payment has been made as a genuine compromise of the proceedings without any intention to give a gratuity. In the absence of any evidence to the contrary, the payment ought not to be chargeable to tax as a ‘benefit’.

The Inland Revenue generally does not like the £30,000 tax exemption available where payments are made ‘in connection with’ the termination of employment. It is therefore no surprise that you have received a letter challenging the treatment of the payment, particularly since the order for reinstatement has the effect of treating the individual throughout as though he had not been dismissed. I do not know whether the Revenue is intending to appeal the case of Wilson v Clayton to the House of Lords, but it will be extremely concerned that this decision could leave the £30,000 tax exemption open to abuse by employers in the future.

Employers are reminded that it is possible to seek advance clearance from the Revenue when it is not clear if a termination payment is properly chargeable to tax. This could happen, for example, where an employer is proposing to pay a departing employee in lieu of notice pursuant to his contract of employment but chooses to pay that sum instead under a compromise agreement as ‘compensation for loss of office’ so as to attract the £30,000 tax exemption. Seeking advance clearance from the Revenue however is a timely process and can cause payment to be significantly delayed. The Revenue also prefers not to give advance clearance. The majority of employers are therefore prepared to take a view on the taxable treatment of such payments and are well advised to secure an indemnity from the departing employee in the event the Revenue deem tax is due on the payment.

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