Taxation of settled discrimination claim

The decision of the First Tier tax Tribunal in L v HMRC is a useful reminder of the complexity of the rules in relation to tax treatment of settlement payments.

L raised Employment Tribunal claims for unfair dismissal, discrimination and equal pay. The matter was settled and a payment made to the Claimant in which the first £30,000 was paid free of tax and the remainder was subject to tax deductions. The agreement did permit the Claimant to make representations to HMRC for different tax treatment in her tax return.

The First Tier Tax Tribunal overruled HMRCs original determination and found that:

• Amounts in respect of deferred consideration under a bonus scheme were income and fully taxable as they related to rewards that had been earned for past service.
• Amounts attributable to an equal pay claim were deferred compensation for lost earnings and were fully taxable.

• Amounts attributable to unfair dismissal were compensation for termination of employment and up to £30,000 could be paid free of tax deductions.

• Amounts attributable to injury to feelings for discrimination were not earnings and were not therefore taxable.

• Amounts attributable to the consequences of discrimination during employment were not earnings and therefore not taxable in this case. What had happened here was that due to discrimination, the individual had missed out on the opportunity to generate business and to increase her earnings. HMRC had considered this to be “earnings-related compensation” and therefore taxable. The First Tier Tax Tribunal disagreed. They said that the mere fact that the measure of the damage caused to the Claimant was the financial loss did not of itself mean that the amount was a payment for services and therefore earnings. The Claimant missed out on future financial opportunities as a result of discrimination and this should not be treated as earnings for tax purposes.

This decision not only highlights the complexity of the tax treatment of settlement payments, but also the importance of allocating settlement payments to various heads of claim. Where there is a Tribunal judgement, a judge will be clear as to what compensation relates to which claim. In a settlement agreement, this is not always the case, but there are good reasons for splitting out the sums although that should always be a genuine assessment of the damages (i.e. an employer cannot unrealistically apportion the whole of a settlement to a non-taxable element (eg injury to feelings) if no Tribunal would award that high a sum for that element).