Tax tribunal rules payment in settlement of discrimination claim was taxable

The tax treatment of termination payments is always an important issue but especially so in high value settlement negotiations where the liability for the tax element could make or break the agreement, depending on where it falls. So, it’s no surprise that a ruling from the Upper Tribunal on the scope of that tax liability has generated so much interest in employment circles.

This is the case of Mathur v HMRC with the Upper Tribunal confirming that the test of whether a termination payment is taxable is a wide one. On the facts, the court ruled tax was payable and so the claimant lost out on almost £3m which she had expected to receive as part of her £6m settlement but which instead went in tax to HMRC. We’ll speak to a tax specialist about the ruling and the lessons employers can take from it. 

A reminder. Termination payments that fall under the relevant income tax legislation - section 401 of the Income Tax (Earnings and Pension) Act 2003 - are taxable, subject to the first £30,000 which is tax free. That provision says that any payment or benefit received "directly or indirectly in consideration or in consequence of, or otherwise in connection with the termination of a person's employment" will be caught. In contrast, payments for discrimination not related to the termination of employment can therefore be paid free of income tax. 

The facts briefly. Shivani Mathur, was global head of economic resources at a global bank in London until she was dismissed along with six others in the aftermath of the Libor scandal. She went on to bring various claims against her former employer including discrimination and victimisation. Some of the claims related to the claimant's alleged treatment prior to the termination of her employment. Other claims related to the actual termination of her employment.

The dispute was ultimately settled under a settlement agreement with a payment agreed of £6m. The agreement stipulated that the sum would be paid net of tax, with the £30,000 tax free element set aside. That deduction amounted to almost £3m. Ms Mathur sought to argue that the settlement sum should be apportioned so that the amount attributable to her pre-termination claims fell outside section 401 and therefore be paid tax-free. Ultimately the case reached the Upper Tribunal which ruled that that the entire settlement sum fell within the scope of section 401 and was therefore taxable as employment income. It wasn’t possible to apportion part of the settlement sum in order to account for the pre-termination claims. The termination was, essentially, the trigger for the other discrimination claims based on events that took place prior to the termination.

So, the claimant in this case ended up with a much smaller settlement than she expected although it’s worth highlighting that the bank, for its part, had been clear all along that they would be deducting the tax and handing it to the Revenue. However, we’ve seen many cases over the years where a misunderstanding in the settlement negotiations, or a lack a care, or both, results in employers having to pay the grossed-up amount, effectively footing the tax bill themselves, which can be a very expensive mistake.

So, let’s hear more on that point, and on this case. Chris Thomas is a tax specialist and earlier he joined me by phone to discuss it:
Chris Thomas: “I think it's worth just briefly reminding ourselves of the fundamentals of how the tax regime actually applies to these payments because your default position will always be that the payment is connected with the termination of the employment. That’s a very wide test - it only has to be indirectly connected or otherwise in connection with termination. So, if you're going to argue that any amount of payment that's being made under that settlement is not caught by that very wide residual charging provision, it needs to be very clear as to exactly why it isn't, and the basis on which it wouldn't be would be that this is a payment really only limited to injury to feelings because any payment for economic loss or loss of earnings, even if it relates to discrimination, is generally not going to be tax free and is going to be caught by that wide charging provision. So, you need to be very clear that (a) there were these acts of pretermination discrimination and not bound up with the  termination; and (b) as to exactly what part of the payment that is being made is being treated as relating to that?”

Joe Glavina: “The claimant in this case ,Chris, ended up with a lot less money than she expected from the settlement so clearly something went badly wrong from her point of view didn’t it?” 

Chris Thomas: “Yes, I think this kind of underlines the importance of being very clear from the outset. I know that's often very challenging because it may be conversations have already happened, you know, expectations have already been set running perhaps before the HR team get properly involved, and certainly before any tax considerations are thoughts about, but it is really important and there are a number of reasons why it's important. One of those is that, as I think this case emphasised, and it's a slightly different point to the one you've mentioned but I think it's worth making, that if you're going to be wanting to put weight at the point of the settlement agreement on apportioning to pretermination discrimination, really you'd want that to be quite clearly asserted in the claim and the way the parties have proceeded to be consistent with that, rather than trying to shoehorn it in at a late stage when you come to think about the tax treatment. To go to the point you made, Joe, I think it is from the employers perspective very important to set expectations around the fact that how they understand that payment is going to be taxed and to make that clear at an early stage and not, as we do sometimes see, to almost have this assumption that oh, well, it's a discrimination case therefore it will be fine and we will be able to make a payment for injury to feelings on a tax free basis because whilst that might be true in certain cases it isn’t a universal position by any means.”

Joe Glavina: “In this case the tax bill was close to £3m, so a huge amount, and the liability for that fell on the claimant. How do you make sure in the negotiations that everybody understands what the individual is actually going to end up with because it could be a deal-breaker?”

Chris Thomas: ““So, I think a lot of it probably comes down to education of the manager population because they're the ones who are going to be having these conversations at the early stages, and just making sure that the systems and processes are such that, well, ideally, obviously, nothing would be set or promised to these employees before HR involved, but we all know that might not be wholly realistic. So, it does come down, I think, to making sure that there are clear policies and that there's clear education and training to the people who are going to be having these conversations so that they understand the parameters of what they are operating within and what they can and can't offer and in particular to be really careful not to make promises of net amounts because that gets very difficult to unpick if, actually, it turns out subsequently that there is going to be a need for the payment to be taxed because of something they hadn't thought about or realised, and then, of course, you are in to territory of having to gross up, potentially, which gets very expensive.”

Joe Glavina: “In your experience, Chris, do we see employers getting this wrong and finding themselves having to pay the individual the grossed-up amount?”

Chris Thomas: “Yes, quite regularly. It happens more often than you might imagine in that, as I said, it’s very difficult from a negotiation perspective once a promise has been made, and an expectation has been set for that employee that they will be able to get a certain amount in their hands on a net basis to then try to row back from that and say, oh, well, actually sorry. Even if there might be a clause in the agreement that purports to do that, it really makes negotiations very difficult and unless the employer is in a very strong negotiating position they've very often left with little option, frankly, to get the deal over the line, but to have to gross up.”

Joe Glavina: “Finally, Chris, anything else to add?”

Chris Thomas: “I think the only other point, and we have touched on this, is that obviously you've got to be clear as to the basis on which you are apportioning to this pre discrimination injury to feelings, but assuming that the facts do support it, and we have to bear in mind the Vento guidelines here as well of course, but if they do, then it is really important that it gets reflected specifically in the settlement agreement and you don't just have one lump sum that's paid and then, albeit treated in different ways for tax purposes, it needs to be really clearly spelled out in the agreement and I know we as a firm would always try to make sure that happens, but if there is an agreement that perhaps has been dealt with in-house, it's a really important thing to do because, if you don't do that, you end up falling back on the default assumption, as in this case, which is treated as connected with termination and you don't get the benefit of that extra tax free amount.”

That case is Mathur v HMRC and is a decision of the Upper Tribunal. We’ve put a link to the judgment in the transcript of this programme for you. 

LINKS
- Link to judgment: Mathur v HMRC