Settlement sum representing injury to feelings was taxable

In Moorthy v Commissioners for HM Revenue and Customs, the Tax and Chancery Chamber of the Upper Tribunal has held that a sum paid to an employee under a settlement agreement in respect of injury to feelings was not exempted from income tax under S.406 of the Income Tax (Earnings and Pensions) Act 2003. Although S.406 takes payments made in respect of injury to an employee outside the charge to tax, ‘injury’ in this context did not include injury to feelings. The EAT’s decisions to the opposite effect in Vince-Cain v Orthet Ltd (Brief 770) and Timothy James Consulting Ltd v Wilton 2015 ICR 764 were wrongly decided.

After M was made redundant by JE Ltd in March 2010 he brought proceedings for unfair dismissal and age discrimination. Following mediation, he reached a settlement agreement with JE Ltd under which it agreed to pay him ‘an ex gratia sum of £200,000 by way of compensation for loss of office and employment’. JE Ltd treated the first £30,000 as exempt from tax by virtue of S.403 ITEPA but deducted income tax at the basic rate from the remainder. When M completed his tax return he treated the whole sum as being tax free. HMRC disagreed and issued a closure notice. On appeal, the First-Tier Tribunal (FTT) found that the whole of the settlement sum had been paid in connection with the termination of M’s employment under S.401 ITEPA and so was chargeable to tax pursuant to S.403. M appealed against that decision to the Upper Tribunal. Among other things, he argued that the settlement sum was taken out of S.401 by S.406(b) ITEPA, which exempts from income taxation a payment or benefit made ‘on account of injury to’ an employee.

The Upper Tribunal dismissed the appeal. It agreed with the FTT that the entirety of the £200,000 settlement sum fell within S.401 as a payment made in connection with the termination of M’s employment. The section applies to payments made even where the termination was fair and lawful and includes non-pecuniary awards, such as damages for injury to feelings. Even if the sum paid might exceed the statutory maximum that could be awarded for unfair dismissal, that did not mean that the excess was unconnected with the termination of the employment.

As for the exemption in S.406, the Tribunal could not accept that, insofar as the sum represented damages for injury to feelings, it was a payment on account of ‘injury’. The meaning of ‘injury’ in S.406 ITEPA is context-specific. It could not be read as exempting all payments made by an employer in respect of an injury to an employee; rather, it was intended to apply to injuries that led to the termination of employment or to a change in duties or level of earnings. In so holding, the Tribunal stated that the EAT was wrong to decide that injury to feelings was covered by S.406 ITEPA in Vince-Cain v Orthet Ltd and Timothy James Consulting Ltd v Wilton. The obiter reasoning of the Chancery Division in Horner v Hasted (Inspector of Taxes) 1995 STC 766 was to be preferred.

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