Should payment under a settlement agreement be taxed as 'earnings'?

In a recent case, the First-tier Tribunal (FTT) held that a payment made to an employee under a settlement agreement in settlement of a potential race discrimination claim should not be considered earnings and was not taxable as such.

This is the first decision as to whether discrimination payments that are calculated by reference to loss of earnings are taxable under section 62 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA).

In A v Commissioners for HM Revenue and Customs, A was employed as a trader at a bank. He raised a grievance against the bank on the basis of race discrimination. Amongst other things, A asserted that he had been underpaid in his discretionary bonuses for a number of years and had not received salary increases because of his race.

A was later informed that he was being made redundant and was paid statutory and contractual redundancy payments. He was also offered an additional £600,000 under a settlement agreement, which was intended to be a full and final settlement of any potential claims he may have. HM Revenue & Customs (HMRC) took the view that the payment was to recompense A for the shortfall in his salary and bonuses and therefore taxed it as earnings under section 62 of the ITEPA.

The FTT held that the payment made under the settlement agreement was to settle a potential discrimination claim and therefore did not constitute an emolument of employment. Amongst other things, the FTT stated that:

• the payment had not been made in return for A's services but instead to reflect his right not to be discriminated against under statute (now the Equality Act 2010)
• it was not relevant whether A's discrimination claim had any chance of success as this did not affect the status of the payment. The only thing that was important was that the payment had actually been made to settle a discrimination claim
• the fact that earnings were involved and that the shortfall in payment would not have arisen if it were not for the fact that A was an employee was not enough to bring the payment under the definition of 'earnings'

It was relevant to consider the taxation of the payment under section 62 ITEPA (relevant to earnings), rather than section 401 (relevant to termination payments), because the discrimination existed long before the redundancy, in relation to which A received a separate payment.

Best Practice

This case is seemingly good news for employees receiving settlement payments. However it is important to note that this was a decision about taxation as 'earnings' under section 62 ITEPA. It therefore needs to be distinguished from rulings in respect of section 401 ITEPA (where tribunals have found that compensation payments for termination due to discrimination fall to be taxed under section 401).

The decision is helpful to employers who choose not to document a specific reason for a settlement payment as it shows that the motive of the employer for the payment will be considered, rather than the wording of the agreement.

For more information, please contact Charlotte Williams in our Employment Law team on 0117 314 5219.