We delve further into which types of non-pecuniary rewards are taxed when an employer makes a settlement payment to a former employee.
Injury to Feelings
As well as compensating for financial loss, employers can make settlement payments to employees, and tribunals can make orders for payment, to compensate for non-financial loss, including either injury to feelings, where no medical injury is required, and 'injury' under section 406 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) which covers personal injury, such as disablement and psychiatric illness:
- injury to feelings caused during the course of employment
- injury to feelings arising out of termination.
With regard to injury to feelings, the tax tribunals have focussed on whether payments can be said to be in connection with the termination of employment, and therefore taxed under section 401 ITEPA 2003 (under which the payment is subject to income tax, save for the first £30,000).
By contrast, employment tribunals have focussed on whether 'injury' under section 406 can include injury to feelings.
In Timothy James Consulting Ltd v Wilton, the Employment Appeal Tribunal decided the employee's compensation for injury to feelings fell within the section 406 exemption, and it was irrelevant whether the payment was linked to her termination, even though this was in conflict with tax authorities at the time.
Moorthy v Commissioners for HMRC
Mr Moorthy suffered injury to feelings caused by the termination of his employment on allegedly discriminatory grounds. He unsuccessfully argued that the compensation received in a settlement agreement with his employer should not be taxed.
We reported on the First-Tier Tribunal's decision here.On hearing his further appeal, the Upper Tribunal (Tax) decided that the payment did not fall within the exception under section 406 ITEPA 2003. Although part of the sum paid was for injury to feelings, the injury caused to Mr Moorthy was as a result of the termination of his employment, rather than any action taken by his employer before termination.
On this basis, the Upper Tribunal upheld the First-Tier Tribunal's decision, finding that the settlement payment should be taxed under section 401 ITEPA 2003.
This case only looks at one aspect of injury to feelings; that caused by the termination of employment. It clarifies that payments made to compensate employees for injury to feelings arising out of termination should be taxed under section 401 ITEPA 2003.
However, it seems that employment tribunals and HMRC have still not agreed on the tax treatment of compensation for injury to feelings caused during the course of employment.
The decision reiterates our previous comment that the scope for taxation of settlement payments made on termination under section 401 ITEPA 2003 is very wide and employers should ensure that robust indemnity provisions are in place. Employers could also consider seeking HMRC clearance as to the appropriate taxation of settlement payments in complex situations.
The decision is also a reminder to employers that any payment specifically to compensate an employee for injury to feelings during employment should be clearly set apart from the rest of the settlement payment. The injury to feelings payment should be proportionate, documented and in accordance with the 'Vento bands' (being three ranges of pay established by the Employment Tribunal for compensation for injury to feelings depending on the severity of the offence).