Injury to feelings are (almost always) taxable under a settlement agreement

27 Jan 2016

The Upper Tribunal Tax and Chancery Chamber has just promulgated the decision in the case of Moorthy v The Commissioners for Her Majesty’s Revenue and Customs [2016] UKUT 13 TCC which concerned a £200,000 payment by the employer to Mr. Moorthy following a mediation after Mr. Moorthy had submitted a complaint to the Employment Tribunal that his dismissal by reason of redundancy was both unfair and an act of discrimination on the grounds of his age. Mr. Moorthy’s ex employer paid the first £30,000 free of taxation and then deducted £34,000 in tax from the £170,000 balance before paying it to him. Mr. Moorthy put his head above the parapet when he indicated in his annual tax return that this tax should not have been deducted and asked for it to be repaid to him by the Revenue; they then opened a case against him. 

In the Upper Tribunal Mrs. Justice Rose firstly had to consider whether s.401 of Income Tax (Earnings and Pensions) Act 2003 (“ITEPA”) was applicable to the payout that Mr. Moorthy had received. She then had to go on to consider, if it was subject to taxation under s.401 ITEPA, whether Mr. Moorthy was entitled to say that it should be excluded from taxation pursuant to s.406(b) ITEPA as a payment or benefit “on account of injury to… an employee”. Mr. Moorthy’s case was that this sum represented compensation for ‘injury to feelings’ which to discrimination lawyers is a bread and butter phrase.

As to the first point Rose J identified the proper methodology as being (at para. 38):

"The correct question posed by section 401 is: was the payment received, directly or indirectly, in consideration or in consequence of, or otherwise in connection with, the termination of employment? The existence of a claim for discrimination may be relevant if the discrimination is unconnected with the termination of employment but it does not change the question to be addressed. In our view, the question remains is there the necessary connection between the payment and the termination of employment?"

Rose J was emphatic that "when determining whether a payment received in connection with the termination of employment falls within section 401 ITEPA there is no distinction between non- pecuniary aspects of the award, such as injury to feelings, and pecuniary aspects such as financial loss”. And therefore in this case, where there were no allegations of discrimination being advanced prior to the decision to dismiss, Rose J found that all of the monetary sum was sufficiently close to the termination of employment that s.401 ITEPA would apply. 

All of the above is perhaps perfectly understandable to the employment lawyers who are familiar with settlement agreements and the structuring of them. However, here’s the stinger….

54. In our judgment, even damages to reflect non-pecuniary matters fall within section 401 ITEPA if they are connected with the termination of employment (or the other events set out in section 401(1)(b) and (c))….

We have all seen many a settlement agreement structured so as to provide that a significant part relates to an award for injury to feelings. However, in light of this decision, unless the payment made under a settlement agreement includes an amount which is to compensate for earlier acts of discrimination which were almost nothing to do with the termination of employment (see para. 55 of the Judgment for this 'side-door' possibility), this is a pointless exercise; it is all taxable pursuant to s.401 ITEPA and s.406(b) ITEPA is of no use for a mere discrimination claim as opposed to a personal injury claim because (at para. 63) Rose J said:

"we consider that 'injury' in section 406 refers to a medical condition and does not include injury to feelings”. 

Far more careful structuring of settlement agreements is therefore now required in order to properly ensure that ITEPA and the Tax Man won’t try to take an unexpected bite!


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