Settlement Agreements - Sums Paid in Respect of Restrictions Taxable as Earnings

An Overview of the Case

In the case of Mrs A v The Commissioners for His Majesty’s Revenue and Customs, Mrs A entered into a settlement agreement with her employer, under which it was agreed that her employment would terminate and she would receive a significant amount of compensation. This followed a grievance by Mrs A in which she made various allegations against the owner of her employer company, including allegations of sexual harassment.

Mrs A was paid over £1 million as a 'Compensation Sum' and her employer taxed this under section 401(1) and 403(3) of the Income Tax (Pensions and Earnings) Act 2003 (ITEPA) as a payment made "directly or indirectly in consideration or in consequence of, or otherwise in connection with, the termination of [her] employment". Accordingly, Mrs A received £30,000 of the Compensation Sum free from deductions and the rest was paid net of income tax.  

Mrs A challenged the tax treatment of the Compensation Sum with HMRC and sought a repayment of tax paid. She argued the payment was not chargeable under these provisions, nor any other provisions, and that she should have therefore received the full amount without deductions for tax. HMRC rejected this and agreed with the employer that the payment was chargeable to tax under sections 401 (1) and 403(1) ITEPA.

Section 225 of ITEPA stipulates that payments made to individuals entering into a "restrictive undertaking in connection with the individual's current, future or past employment" are taxable as earnings.

Interestingly, in view of this, Mrs A argued that the Compensation Sum was wholly in consideration of her agreeing to enter into the confidentiality and non-disclosure obligations in the settlement agreement. She asserted that section 225 should not apply as the restrictions placed on her did not restrict her in respect of employment activities.  

Decision

The Tribunal found that it was correct to consider the application of section 225 ITEPA before section 401 ITEPA in accordance with the statutory 'order of priority'. It was satisfied that section 225 applied in the circumstances and therefore the payment was taxable as earnings. In the Tribunal's view, the Compensation Sum had therefore been undertaxed, not overtaxed.

What Are the Implications of the Case?

The judgement sets out the detail of the restrictions Mrs A entered into. These are relatively 'typical' confidentiality provisions and other restrictions, such as preventing Mrs A from pursuing existing complaints or raising further complaints, making derogatory statements etc. It is therefore possible that this case does somewhat call into question the tax treatment of compensation paid under settlement agreement containing such provisions.

However, in our view, the case is distinguishable on its facts. Mrs A pursued some rather novel arguments and relied on her assertion that the Compensation Sum was primarily paid for her silence and the settlement agreement was therefore effectively a non-disclosure agreement. In persuading the Tribunal of this, it follows that the payment would be chargeable to tax under section 225 ITEPA.

Significantly, HMRC were content that the Compensation Sum had been correctly taxed under section 401 ITEPA and non-statutory HMRC guidance notes that they do not regard undertakings in termination agreements to discontinue legal proceedings relating to the employment or reaffirming undertakings given as part of the original terms of the employment as having any chargeable value within section 225.

Parties entering into settlement agreements should take care to consider the correct tax treatment of payments made and, where additional restrictions are imposed on employees, they should consider payment of specific consideration in return for such undertakings/restrictions. It is also possible to more fundamentally restructure settlement deals taking account of the tax treatment of consideration or compensation paid and we would recommend taking advice, particularly in relation to high value settlements.

For more information regarding settlement agreements, please contact Charlotte Rose in our Employment team on 0117 314 5219, or complete the form below.