Tax on termination: injury to feelings payments are taxable

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Summary: A new tax case brings some much needed clarity to the tax treatment of termination payments. In Moorthy v. HRMC, the Upper Tribunal confirmed that apart from the usual £30,000 exemption (or one of the less common exemptions such as a payment for injury or disability) any termination-related compensation is taxable. This is regardless of whether the payment is to compensate for financial loss, for injury to feelings arising from discrimination, to protect the employer’s reputation or otherwise.

A new tax case brings some much needed clarity to the tax treatment of termination payments. In Moorthy v. HRMC the Upper Tribunal (Tax and Chancery Chamber) confirmed that apart from the usual £30,000 exemption (or one of the less common exemptions such as a payment for injury or disability) any compensation received in connection with termination of employment is taxable. This is regardless of whether the payment is to compensate for financial loss, for injury to feelings arising from discrimination, to protect the employer’s reputation or otherwise.

The reason for making the termination payment isn’t important

In Moorthy, the employee argued that the £200,000 compensation he received under a settlement agreement was all tax free because it was for age discrimination related to his dismissal. The Upper Tribunal, confirming the First-tier Tribunal’s decision, said that the only issue is whether the compensation payment is connected to the termination of employment. If it is connected to termination, the payment is taxable under the termination payments regime. As the compensation in Moorthy was all related to the termination of his employment, aside from the usual £30,000 tax free exemption, the rest of the payment was taxable.

Injury to feelings termination payments don’t fall within the ‘injury or disability’ exemption

The Upper Tribunal also overruled a recent EAT decision which said that injury to feelings payments for discrimination were tax free because they fell within an exemption that says termination payments ‘on account of injury’ can be paid tax free. The Upper Tribunal said that only medical conditions fell within the ‘injury’ exemption and ‘injury to feelings’ arising from discrimination didn’t satisfy this test.

What this means for employers

The Moorthy Upper Tribunal decision puts to rest conflicting decisions of the First-tier Tribunal below, not least the controversial Oti-Obihara v. HMRC case which some individuals have historically tried to rely on to argue that their termination payments should have much more generous tax free treatment.

It is still possible, however, to pay tax free compensation where the discriminatory treatment is not termination-related. In more complicated situations where discriminatory treatment happens both during employment and on termination, employers should appropriately apportion the compensation to reflect the discriminatory treatment during employment (which can be paid tax free) and termination-related discriminatory treatment (which is taxable, subject to the usual £30,000 exemption).

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