Tax implications of discrimination settlements

This article explores a landmark case of of L v HMRC [2024] UKFTT 001044 where an employee’s settlement for discrimination was disputed by HMRC, raising critical questions about tax treatment of damages. Delving into the intricacies of employment law and tax regulations, it examines the implications for future discrimination claims and offers insights into the complex interplay between employment rights and tax obligations.

Factual background

L was employed as an executive director in capacity as the team leader on terms which paid her a base salary plus a discretionary year-end cash bonus and deferred compensation under a long-term incentive plan (LTIP). As per her offer letter, the discretionary cash bonus for the first year of employment was a fixed amount however, any entitlement to future year bonuses would be determined by reference to a non-exhaustive list of factors including business and market conditions, individual performance, and conduct.

Normally each team had a single leader who was rewarded by reference to the team’s performance. However, in L’s team, there was another co-team leader who worked alongside L. On 15 April 2013, L was made redundant by her employer. L appealed the redundancy decision. The employer confirmed the decision on 19 August 2013. A claim filed on 11 July 2013 with the Employment Tribunal alleged discrimination, harassment, unfair dismissal, and inequality of pay. L successfully argued that she had a protected characteristic which was recognised under the Equality Act 2010 (“Equality Act”) and the fact that there was a co-team leader meant that L had fewer opportunities to earn bonuses and to participate in the LTIP.

The employer defended the claims but by 11 October 2013, had indicated a willingness to compromise. By an agreement dated 31 March 2014, the claims were compromised in full and final settlement of all claims past, present and future arising from L’s period of employment.

The settlement sums were paid by the employer to L net of Income Tax and National Insurance contributions on the basis that all but £30,000 of the total sums paid were subject to tax. Under the terms of the settlement agreement, the appellant was entitled to make representations to HMRC as to any alternative tax treatment of the payments made pursuant to the agreement.

L filed her 2014/15 tax return on the basis that the settlement sum was assessable to tax against which the tax-free sum of £30,000 was offset. The balance was considered to be outside the charge to Income Tax. This was because, in L’s view, the balance did not derive from her employment but from her rights under the Equality Act.

On 16 January 2017, HMRC opened an enquiry into the return. On the basis of the information received through the enquiry, HMRC ultimately concluded that L had failed to treat the settlement payment correctly, resulting in the issuance of a closure notice by HMRC on 10 May 2021 amending L’s self-assessment for the tax year ended 5 April 2015 and assessing her to £115,900.88 additional Income Tax (“Closure Notice”).

L’s appeal to the First Tier Tribunal (FTT) was against the Closure Notice. Part of L’s claim related to her allegation that her role had essentially been split by hiring an additional person, which reduced her opportunity to develop business. As a result, part of the settlement did not relate to a claim for payment from employment, but to work she didn’t do because she was prevented from doing so. It was claimed that this was an act of discrimination.

HMRC’s contention was that the substantive right in the claim was the recovery of employment income to which they were entitled had the employer not acted in a discriminatory fashion.

Legal background

Under section 62 of the Income Tax (Earnings and Pensions) Act (ITEPA) 2003, income is taxed as employment income if it is from the employment. Further, section 401 ITEPA 2003 deems income to be employment income if it is not otherwise taxable as employment income, but is subject to the £30,000 exemption from tax. This applies to income which is “in consequence of or in connection with the termination of the employment”.

The case of Mathur v HMRC [2024] UKUT 00038 (TCC), applying the earlier judgment of Moorthy v HMRC [2018] STC 1028, in the context of section 401 ITEPA 2003, confirmed that the words “in consequence of or in connection with” are very broad and they are broader than the “from” in section 62 ITEPA 2003. Therefore, if a payment is made in the context of a termination, it is very difficult to say that it is not made in connection with the termination resulting in such a payment being taxable subject to the £30,000 exemption.

Individuals have statutory rights under the Equality Act. These rights have been analysed as creating a right to pursue a claim for a statutory tort. This sits uneasily with the judgment in Mairs v Haughey [1993] STC 569 (Mairs). Mairs established that a payment made to satisfy a contingent right will derive its character from the nature of the payment it replaces. In Mairs, the taxpayer received compensation for the loss of an enhanced redundancy scheme, and it was held that the payout should be taxed in the same way as a payment from the enhanced redundancy scheme. By way of illustration, HMRC applies Mairs to treat a payout under an equal pay claim as being taxable under section 62 ITEPA 2003.

It is settled law that if a discrimination claim payout is made in the context of a termination, then it is caught by the “in consequence of or in connection with test” and it is subject to tax under section 401 ITEPA 2003.

Prior to FTT’s decision in the current case, HMRC’s view on pre-termination discrimination payments was determined by two cases, A v HMRC [2015] UKFTT 189 and Pettigrew v HMRC [2018] UKFTT 240. HMRC’s view is that there needs to be an evidentiary exercise carried out to determine whether the discrimination payment is attributable to the termination payment or not.

In A v HMRC, where the taxpayer was seeking damages for lost opportunities to make money, the discrimination payment was made outside the context of a termination. Here the judge held that an Equality Act claim was a statutory right, and it was not ‘from the employment’. Therefore, the Equality Act claim fell outside section 62 ITEPA 2003, according to the judge.

Pettigrew v HMRC was a claim by a part-time judge. He claimed successfully that he had not been treated in the same way as a full-time judge because of his part-time status. The FTT declined to follow A v HMRC in determining the tax treatment of the monetary aspect of his claim. The FTT held that A v HMRC had been wrongly decided. This was because A v HMRC did not consider Mairs. The FTT took the view that the sums that the claimant was seeking were salary arrears and so were taxable under section 62 ITEPA 2003.

There are therefore two contradictory FTT decisions.

HMRC’s position in L v HMRC relied on Pettigrew v HMRC and therefore took the view that the only aspect of a discrimination claim that can fall outside section 62 ITEPA 2003 and assume tax-free status (where the discrimination is not in the context of the termination of an employment) is a claim for injury to feelings. Therefore, the damages for a claim that the employee was prevented from performing work on account of discrimination would not fall outside section 62 ITEPA 2003.

The decision

To reach a conclusion, the FTT dealt with the potential inconsistency between A v HMRC and Pettigrew v HMRC. In the context of the case, the FTT said that in Pettigrew the part-time judge was in substance bringing a claim for arrears of pay. This was because it was possible to draw up a comparison between what Mr Pettigrew had earned and what a full-time judge would have earned in those circumstances.

However, the judge took the view that in A v HMRC, the taxpayer was seeking damages for lost opportunities to make money and so there was a subtle distinction between the two cases. The judge took the view that in the case before it the claimant was in a set of circumstances which were analogous to those in A v HMRC. In other words, L was bringing a claim for the loss of opportunity to make money. Therefore, the judge held that the financial discrimination award received by the claimant was not taxable under section 62 ITEPA 2003.

Conclusion

Some important points arise as a result of this decision:

• The decision in L v HMRC is at the level of the FTT and therefore HMRC could ignore it as being inconsistent with the manual.
• In Mairs, the Court had held that compensation for the loss of a right should take on the same tax treatment as the sums which would have been paid out had the right come to fruition. Applying this logic, if the claimant in L v HMRC had not been discriminated against, the sums that the claimant would have received would potentially have been taxed as employment income.
• The rationale provided for the decision in L v HMRC gives rise to potential arguments in a number of discrimination claims that fall outside the context of a termination, especially where a failure to provide an opportunity is often argued as being the basis of the claim. For instance, in regard to claims involving discrimination which prevent a promotion.