This recent judgment made in the First-Tier Tribunal highlights to employers the importance of apportioning the component parts of a settlement payment under a compromise agreement, so that there is no confusion as to the tax treatment.
The Appellant, Mr Obihara, was employed by a US investment bank in London. In the course of his employment, he was subject to racial discrimination and harassment, which led to internal grievance proceedings.
Before the matter came to hearing at the employment tribunal, Mr Obihara negotiated a settlement with his employer, whereby his employment was terminated and he received a settlement payment of £500,000. This was on the condition that he waived all legal claims he might have against his employer.
The litigation against HMRC arose because Mr Obihara did not include the settlement payment on his self-assessment tax return, on the grounds that it was neither income from his employment, nor a payment made in connection with the termination of his employment.
HMRC issued a closure notice on 15 September 2009 amending Mr Obihara's self-assessment tax return, so that £28,000 of the payment of £500,000 was treated as damages for injured feelings and therefore was not taxable; the balance was treated as a payment received in connection with the termination of Mr Obihara's employment, and therefore subject to income tax (therefore a further £72,192.54 income tax would be payable).
Mr Obihara appealed this closure notice arguing that out of the £500,000 only £18,206.40 is a payment in connection with the termination payment of his employment, with the balance representing a payment of damages for racial discrimination and harassment, which is not liable to income tax under s.401 ITEPA 2003.
HMRC's case was that much of the settlement payment was received by Mr Obihara in respect of discrimination which was the cause of the termination of his employment, and therefore was in connection with such termination and in consequence within the s.401 ITEPA 2003 charge.
HMRC accepted that at least part of the settlement payment (approximately £28,000) in their estimation was received by Mr Obihara as damages for injury to his feelings as a result of racial discrimination, but that the balance of the payment was received in connection with the termination of Mr Obihara's employment.
HMRC relied on the case of Walker v Adams . This case showed that a compensation payment made on the occasion of the termination of employment for discrimination is taxable to the extent that it is compensation for financial loss suffered by reason of the termination of the employment.
The First-Tier Tribunal referred to Mr Obihara's compromise agreement with his employer, which outlined that the settlement payment was paid for three purposes: i) as compensation for the termination of Mr Obihara's employment, ii) in satisfaction of all Claims (as defined) in respect of such termination, including the Appellant's claims in the employment tribunal proceedings; and iii) in satisfaction of the other claims as itemised. However, there was no comment in the compromise agreement that in any way apportioned the settlement payment between the employment termination payment and, on the other hand, damages or other compensation for infringement of rights.
The Tribunal judged that is was therefore clear that the settlement payment was made in part in connection with the termination of Mr Obihara's employment, but also in part made in relation to claims he had, or might have had, for violations by his employer.
Consequently, it was held that the sum of £165,000 should be properly regarded as a payment in connection with the termination of Mr Obihara's employment, and that accordingly the sum of £135,000 was chargeable to income tax.
The outcome of this case highlights the importance of apportioning financial compensation and discriminatory damages in a compromise agreement.
The amount attributable to discrimination will not be charged to tax. However, the financial compensation will be taxed within s.401 ITEPA 2003 subject to certain exemptions.