The Taxation of Termination Payments - Injury to Feelings

The Upper Tribunal (UT) has ruled that a compensation payment for injury to feelings made on the termination of employment is subject to tax under Section 401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) (Moorthy v The Commissioners for HM Revenue and Customs).

Mr Moorthy was selected for redundancy by Jacobs Engineering (UK) Limited in March 2010. In the 2009/10 tax year he received statutory redundancy pay of £10,640 from which no Income Tax was deducted. He then brought Employment Tribunal claims for unfair dismissal and age discrimination and, after mediation, entered into a compromise agreement under which Jacobs agreed to pay him an ex-gratia sum of £200,000. Jacobs treated £30,000 of the settlement as exempt from tax under Section 403 ITEPA and deducted Income Tax at the basic rate from the balance. Mr Moorthy completed his 2010/11 self-assessment tax return on the basis that the settlement amount was tax free.

HM Revenue and Customs (HMRC) argued that, as a termination payment, the £200,000 was subject to Income Tax, other than the £30,000 exemption under Section 403 ITEPA. However, as a concession, HMRC offered to reduce Mr Moorthy's taxable income by a further £30,000 as this could be treated as damages for injury to feelings in respect of his discrimination complaint and therefore not taxable.

On appeal, the First-tier Tribunal (FTT) found that:

  • the £200,000 payment was in consideration of the termination of Mr Moorthy's employment and so fell within Section 401 ITEPA;
  • the £30,000 exemption should be reduced to £19,360 to take account of the statutory redundancy pay he had already received; and
  • HMRC should not have made the £30,000 concession as the discrimination of which Mr Moorthy complained had taken place during the redundancy selection process and was therefore in connection with the termination of his employment.

Mr Moorthy appealed to the UT, which upheld the FTT's decision and went on to give guidance on the meaning of Section 406 ITEPA, which provides an exemption from Income Tax where a termination payment is made on the death of an employee or on account of injury or disability. In this context, 'injury' should be interpreted as meaning something which led to the termination of employment or to a change in an employee's duties or level of remuneration. A payment for discrimination arising on termination cannot be made tax free by labelling it as an award for injury to feelings.