Mr A: Was a discrimination claim settlement taxable as earnings?

In Mr A v HMRC [2015] UKFTT 0189 (TC), the First-tier Tribunal held that a payment made by a bank to an employee under a compromise agreement was made to settle a potential race discrimination claim and was not ‘earnings’ from employment for the purposes of ITEPA 2003 s 62. 

 

 

Mr A worked as a trader for a bank from 2003 to 2008. Under his service agreement, he was entitled to a basic salary and he was eligible to participate in the bank’s discretionary bonus scheme. During the course of his employment, Mr A raised a number of grievances with the bank. In particular, Mr A felt that the bonuses awarded to him were low given the profits he had made for the bank, and he argued that he did not receive the salary increases which were awarded to his colleagues. He alleged that this less favourable treatment was as a result of his ethnic origin, and that he was the victim of race discrimination.

 

In late 2007, Mr A was notified by the bank of imminent redundancies, at which point he instructed an employment lawyer in relation to his grievances. The following events then happened.

 

On 19 March 2008, Mr A’s solicitor served a questionnaire on the bank under the Race Relations Act 1976. (Note that the 1976 Act has since been repealed, and race is one of nine ‘protected characteristics’ covered by the Equality Act 2010.) 

 

On 26 March 2008, the bank informed Mr A that he was being made redundant and offered him £1,650 in statutory redundancy pay and an ex-gratia payment of £48,898. The FTT inferred that this offer was made by the bank without knowledge of the discrimination questionnaire. A few days later, the bank offered Mr A an additional lump sum if he signed a compromise agreement (now known as a settlement agreement). Mr A signed the compromise agreement on 9 April 2008. The compromise agreement specified that a statutory redundancy payment of £1,650, an ex gratia payment of £48,898 and the sum of £600,000 would be paid to Mr A. It contained the typical provisions one would expect to see in such an agreement, settling (without admission of liability) all claims Mr A may have in connection with his employment and/or its termination, including claims relating to discrimination and the Race Relations Act 1976.

 

 

The primary issue in the case concerned the tax treatment of the £600,000 payment and whether it was chargeable to tax as earnings from employment pursuant to s 62.

 

HMRC argued that the payment was designed to make good shortfalls in salary and bonus received by Mr A and was therefore earnings from employment. On that basis, HMRC had amended Mr A’s tax return for the year ending 5 April 2009, treating the payment as taxable under s 62. Mr A appealed to the FTT, arguing that the £600,000 was compensation in respect of the race discrimination claim which he had threatened to bring. 

 

The case also looked at the tax treatment of the £1,650 statutory redundancy and £48,898 ex gratia payments, but those aspects of the case are not considered here.

 

 

The FTT held that the £600,000 payment was made to settle Mr A’s potential claim for race discrimination, and was not ‘earnings’ under s 62. Mr A’s appeal against HMRC’s amendment to his self-assessment return was therefore allowed.

 

 

Given that Mr A was ultimately made redundant, the reader may be wondering why ITEPA 2003 s 401 (payments on termination of employment) was not argued.

 

Payment not made in connection with the termination of Mr A’s employment: HMRC agreed that the £600,000 payment did not fall within s 401 – on the basis that the alleged discriminatory treatment related solely to Mr A’s treatment during the course of his employment. The alleged acts which led to the potential claim for discrimination occurred sometime before the redundancy situation arose, and separate payments were made in respect of Mr A’s termination. On that basis, s 401 was not relevant to the appeal.  

 

Was the payment ‘earnings’? Under s 62(2), ‘earnings’, in relation to an employment, means:

 

 

The FTT referred to the classic Hochstrasser v Mayes 38 TC 673 and Shilton v Wilmshurst 64 TC 78 cases on emoluments, noting that the test is whether a payment is a reward for services past, present or future. In particular, Lord Templeman in Shilton said: ‘If an emolument is not paid as a reward for past services or as an inducement to enter into employment and provide future services but is paid for some other reason, then the emolument is not received “from the employment”.’

 

Award calculated by reference to loss of earnings: The FTT considered whether the fact that the compensation payment was calculated by reference to loss of earnings made it taxable under s 62. HMRC disputed Mr A’s assertion that race discrimination was the reason the bank made the payment to him. In response to an enquiry from HMRC, the bank had indicated that (without an admission of liability) it regarded some of Mr A’s claims as holding merit; and recognised the risk that he may have been able to successfully assert rights to higher bonus payments. Accordingly, HMRC argued that the payment was to make good underpayment of salary and bonus to Mr A and was therefore earnings for the purposes of s 62. 

 

HMRC cited cases (Walker v Adams [2003] STC (SCD) 269 and Oti-Obihara [2010] UKFTT 568) where damages calculated by reference to earnings were treated as taxable. However, the FTT noted that these cases concerned termination payments and s 401, which is drafted more widely than s 62. The decisions had not dealt with whether compensation in respect of underpaid salary and bonus due to discrimination is subject to tax under s 62. 

 

What if damages had been awarded by an employment tribunal? The FTT considered what the position would be if an employment tribunal were to award damages for discrimination, and the tribunal judge observed that amounts paid under a compromise agreement should be treated in a similar way: ‘Where damages are calculated by reference to underpaid earnings, while the discrimination may have manifested itself through the way in which the employee was remunerated, the damages arise not because the employee was under-remunerated but because the underpayment was discriminatory.’ The FTT held that an award in these circumstances cannot be described as a reward for services – the award is paid for some reason other than the employment and is not earnings. 

 

Is proof of discrimination required? The FTT considered that it was not necessary for the appellant to show actual discrimination or that they suffered differing treatment – instead, it is necessary for them to produce sufficient evidence from which the tribunal may infer that the reason why the payment was made was to compensate for an actual or potential action for discrimination. 

 

Evaluating the evidence: The FTT considered what the parties said about the purpose of the payment, how they acted and their communications with each other. It acknowledged that there may be multiple reasons why a settlement payment may be made by an employer. 

 

On the facts, the FTT concluded that (while accepting that the bank did not want to make an admission of liability) the payment of £600,000 was made in respect of the claim for race discrimination which Mr A had threatened to make. It considered that the bank did not wish to defend such a claim and the payment was to settle the claim.  

 

Although Mr A had initially raised breach of contract in his grievances (in particular in relation to errors made in calculating one of his bonus payments), the FTT found that the complaint and threatened proceedings ultimately related to race discrimination. A key finding of the FTT was that the service of the discrimination questionnaire was instrumental in the bank negotiating a compromise agreement and offering to pay the additional £600,000.  

 

 

The reason why the payment was being made by the bank was key in the FTT’s analysis. On the facts there was strong evidence that Mr A intended to bring a claim for race discrimination, and that the payment was made to settle the potential claim. 

 

On that basis, the FTT held that the payment could not be taxed as earnings under s 62, notwithstanding the fact that it was calculated by reference to the shortfall in salary and bonus payments. This was a logical conclusion, given the evidence and the arguments presented on behalf of the parties. The case clearly turns on its facts – we can only speculate what the position would have been if the race discrimination questionnaire had not been served or if damages were being awarded for termination as a result of discriminatory treatment.  

 

The FTT did not place significant emphasis on the drafting of the compromise agreement, but advisers should not be complacent. The decision does not change the fact that in looking at payments made under any settlement agreement, it is necessary to consider which charging provisions apply and whether amounts should be split into different parts. 

 

As HMRC’s Employment Income Manual recognises (at EIM12855), when an employment comes to an end, an employee may have a range of claims against the employer and amounts included in a settlement agreement may be taxable under a number of charging provisions, including s 62 or s 401, or may be payable tax-free. 

 

EIM12965 provides guidance (in the context of termination payments) on HMRC’s view of compensation for discrimination. Compensation for discrimination may be paid under several different heads, such as loss of earnings and injury to feelings, and each head needs to be considered separately. On the facts of Mr A v HMRC, HMRC conceded that the £600,000 payment did not fall within s 401 (as the alleged discriminatory treatment took place during the course of Mr A’s employment). Other cases may not be so clear-cut. Accordingly, the decision may turn on its facts but nonetheless it will be interesting to see if HMRC applies for permission to appeal the decision.