Tax Treatment of Payments Relating to Injury and Disability
A recent ruling has provided clarity on how HMRC will assess tax on payments or benefits paid to employees on account of injury or disability.
Background of the Ruling
Under Section 406 of the Income Tax (Earnings and Pensions) Act 2003, payments or benefits provided to employees on account of injury or disability are exempt from income tax and national insurance. To date HMRC has held the view that a payment must be made exclusively on account of injury or disability for it to benefit from this exemption, calling into question the taxable status of payments made for a variety of reasons, one of which is injury or disability.
Howard Ravenspine v HMRC
The employee was in receipt of benefits under her employer's permanent health insurance (PHI) scheme. The PHI provider became reluctant to continue benefits. Following this, the employee entered into a termination agreement with her employer which included a lump-sum payment labeled as compensation for loss of office and termination. The lump sum was intended to settle all claims the employee may have, including any claim for PHI benefits.
HMRC argued that the tax exemption under Section 406 did not apply because the lump sum payment under the settlement agreement was not exclusively made on account of injury or disability.
The First-tier Tribunal rejected this 'all or nothing' interpretation of Section 406. The Tribunal emphasized that the purpose of the disability exemption is to exempt any payment made on account of injury or disability, regardless of whether other payments are involved in the same transaction. Therefore, if a portion of the payment falls within the exemption, that specific element should be exempt.
Conclusion
HMRC have accepted the Tribunal's position and it is hoped that its guidance will be amended to reflect this.
Cases involving these sort of payments are often complicated and can involve large sums of money. As a result it is advisable to seek specialist tax advice in each case. This might involve putting proposed arrangements to HMRC for prior approval before any agreements are signed.
If a settlement agreement is being entered into it is likely to remain good practice to separate out payments made in respect of injury or disability from other payments, such as payments made on termination of employment and payments in respect of accrued holiday.