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Settling an employment claim? Consider tax

When a settlement payment of any kind is made to an employee it is important to get the issue of taxation right.

When a settlement payment of any kind is made to an employee it is important to get the issue of taxation right. During negotiations, parties tend to focus on a ‘headline’ sum and neglect to consider the impact that taxation might have. This can leave claimants feeling ‘short-changed’ and aggrieved when HMRC later demand tax on the settlement payment. 

As a general rule, pure ex gratia payments made under a formal settlement agreement, which relate solely to the termination of an individual’s employment, will be tax free up to a threshold of £30,000. 

By contrast, any payment to which an individual is contractually entitled or relates to past or future service will be taxable in full. 

Sometimes however the distinction between these two types of payment is far from clear. In the recent case of Hill v HMRC the First-Tier Tax Tribunal considered the nature of a payment under a settlement agreement and held that it was subject to income tax because it was made to compensate the employee for a change to the terms of his contract. 

The facts

The claimant, Mr Hill, worked for General Motors UK Ltd (GM) from 1 December 2001 until 1 June 2010. His employment contract included a provision that he was to be located at a specific site (in Bedfordshire) but might also be required to work at other sites within a ten mile radius. 

On 1 January 2007, Mr Hill was seconded to work at Saab City in London, a secondment which continued until 1 June 2010. On that date, Mr Hill’s employment transferred from GM to Saab GB Ltd under TUPE. 

Mr Hill was unhappy with the transfer of his employment to Saab City as he had been hoping to return to GM at the end of his secondment and to continue his career with GM. In particular, he was unhappy about the prospect of continuing to work in London (which was a long way from his home) and the fact that GM had failed to consult with him in advance of the transfer as required by the TUPE regulations. 

He raised a grievance with GM and Saab about these issues and, after a ‘protracted period’ of negotiation Mr Hill entered into a compromise agreement (as settlement agreements were then known) around November 2010, receiving £30,000 which he believed to be tax free. He remained in employment at Saab City. HMRC later challenged the ‘tax free’ status of the payment. 

The decision 

After hearing evidence the Tribunal concluded that the predominant reason for the payment was the fact that Mr Hill was now being required to work in London (despite the term in his contract that he would not be required to work more than ten miles from his home site in Bedfordshire). 

The payment was made in relation to a specific aspect of Mr Hill’s service going forward and was therefore taxable. This conclusion was bolstered by the fact that the agreement stated that Mr Hill could be required to repay a proportion of the sum if he left employment voluntarily within a specific period. The payment was clearly referable to his future employment. 

The Tribunal rejected Mr Hill’s argument that the payment was intended to compensate him for his employer’s failure to consult under TUPE as he could not identify how much of the payment related to this complaint and, significantly, he was already out of time to bring such a claim at the time the compromise agreement was signed.

It also rejected the argument that the payment was made ‘on termination’ of Mr Hill’s contract with GM. The TUPE transfer to Saab had preserved his continuity of employment and there had been no termination.

Comment 

The case demonstrates that payments that relate to a change in conditions of employment where that employment continues will generally be regarded as earnings, and the fact that such payments are made under a settlement agreement will not alter this analysis. 

Most settlement agreements will contain some form of indemnity clause stating that any demand for tax will be met by the employee. It is therefore usually the employee that bears the majority of the financial risk (although the employer is exposed to the risk of any secondary (employers) NICs). It is however important in all cases to carefully consider the nature and purpose of the payment before making any representations to an employee about whether or not a payment will be subject to tax. 

The decision also raises some interesting issues around the interaction of settlement agreements and TUPE transfers. It was noted that the interaction of the tax legislation regarding payments on termination of employment with TUPE transfers is “not entirely straightforward”.

A TUPE transfer could, in some respects, perhaps be viewed as the termination of one employment and the commencement of a new one but the terms of the TUPE legislation specifically provide that a TUPE transfer does not operate to terminate the contract of any transferring employee.

Whilst the decision in the present case did not hinge upon the question or whether or not there had been a termination of Mr Hill’s employment the Tribunal indicated that, if it had, they would have determined that the application of the TUPE would have meant that there had been no termination of Mr Hill’s employment for tax purposes either.

We recently told you about the case of Timothy James Consulting v Wilton which highlighted how difficult it can be to predict whether a payment intended as compensation for discrimination will be taxable or not. This recent spate of important employment-related decisions coming out of the tax Tribunals underline the importance of seeking professional advice when putting together a settlement package.