The tax tribunal in Oti-Obihara v HMRC, has determined the correct approach for tax purposes, of apportioning settlement payments covering claims of discrimination and termination of employment.
Section 401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) allows an employee to receive up to £30,000, tax free, as compensation for termination of their employment. Sums in excess of this are taxed in the usual way. However, HMRC (EIM12965) provides that "any part of the settlement that can reasonably be attributed to discrimination occurring before the termination should be accepted as not being employment income (and therefore taxable) as it is not “connected” with the termination".
The tribunal has confirmed that a compensation payment made to an employee for discrimination is taxable under section 401 of ITEPA 2003 if the discrimination is the cause of the termination of employment but only to the extent that the compensation meets financial loss caused by the termination. Any other amount received as compensation for discrimination, in other words, as compensation for injury to feelings is not earnings from employment and therefore escapes taxation.
Global payments are commonly used when settling employment claims, but the tax implications of such payments are often complicated. Employers may wish to use the settlement agreement to apportion the majority of the settlement payment to injury to feelings caused by the discrimination rather than to the financial loss incurred from the termination in order to reduce tax liability. A failure to clearly apportion the amount may lead to HMRC arguing the whole sum is subject to tax as a payment for termination.
However apportioning large amounts to injury to feelings for discrimination may have a negative impact on an employer's reputation. A balance will therefore need to be struck between reducing the tax burden and preserving the public image of the business.
The case demonstrates the importance of clearly apportioning global settlement payments and agreeing upon tax liability at an early stage to avoid future problems.
For further information on settlement best practice, please contact Alison Graham on 0117 314 5304.
This publication is for guidance only. Reliance should not be placed upon it and nor should action be taken, without obtaining advice in respect of the specific circumstances applicable. We will be pleased to provide such advice or assistance.