“Tax doesn’t have to be taxing.”
So claimed Adam Hart-Davis in the memorable series of noughties adverts in which HMRC tried to persuade us of the virtues of self-assessment.
A typical employment lawyer might tend to disagree. The taxation of employment-related payments is often a vexed issue. It is especially so in high value settlement negotiations, where the liability for tax on the proposed settlement payment might be the difference between reaching agreement and not.
Those of a nervous disposition should look away now. The Upper Tribunal (Tax and Chancery Chamber) has handed down judgment in Mathur v Revenue and Customs Commissioners [2024] UKUT 38 (TCC) in which it emphasised the width of s.401 ITEPA and its ability to render settlement payments as taxable.
Relevant law
ITEPA 2003 s 401(1)(a) provides that payments and other benefits which are received directly or indirectly in consideration or in consequence of, or otherwise in connection with, the termination of a person’s employment are treated as employment income. The first £30,000 of such income, however, can be received tax-free.
The breadth of the necessary connection between the payment and the termination of employment was emphasised by the Court of Appeal in Moorthy v HMRC [2018] STC 1028, where Henderson LJ held:
The word ‘otherwise’ before ‘in connection with’ shows that the kinds of connection envisaged by the section must be wider than the specific examples given of payments and other benefits received directly or indirectly in consideration or in consequence of the termination of a person’s employment (or a change in the duties of or earnings from that employment).
The facts
In 2015, Ms Mathur’s employment was terminated by Deutsche Bank following regulatory investigations into the manipulation of interbank offered rates. Ms Mathur began ET proceedings against DB, alleging harassment, discrimination and victimisation. Following mediation, the parties entered into a settlement. DB paid Ms Mathur £6 million in full and final settlement of her claims without admission of liability.
Significantly, the mediation came after a Preliminary Hearing in the ET proceedings at which she set out the basis of her claims, and their relationship to the termination of her employment, in both a witness statement and in her representative’s skeleton argument.
The bank treated the settlement payment as being connected with the termination. It deducted income tax and NICs under PAYE from the settlement payment above the £30,000 threshold (in the sum of £2,677,460).
Ms Mathur sought repayment of the tax deduction in her self-assessment tax return. HMRC opened an enquiry into the return. It concluded that the sum deducted by DB (other than £44,000) was properly chargeable to income tax under ITEPA 2003, s 401 as a payment received indirectly in consequence of, or otherwise in connection with, the termination of employment.
Ms Mathur appealed to the FTT. She claimed that the settlement payment was not connected to her termination. Rather, the payment arose from the settlement of claims of pre-termination discrimination and from DB’s desire to prevent those claims becoming public.
The FTT decision
The FTT concluded that the settlement payment met the conditions of s.401 in two respects.
Firstly, the settlement payment was received “indirectly in consequence of” the termination. As the FTT put it: “the bringing of the ET proceedings was, substantively and realistically, in consequence of the Termination; and the Settlement Agreement, including its negotiation, was, in the same way, in consequence of the ET proceedings.”
Secondly, the settlement payment was received “otherwise in connection with” the termination. It reached this conclusion for two reasons. The first relied upon the FTT’s existing findings as to the settlement payment being “indirectly in consequence of” the termination. As to the second reason, the FTT relied upon the centrality of the termination to the substance of the claims made which were then settled.
In reaching its conclusions, the FTT placed heavy reliance upon the way in which Ms Mathur had advanced her claims before the ET. The FTT concluded that, by comparison, Ms Mathur had downplayed the centrality of termination to her claims before the FTT.
The FTT also refused to apportion the settlement payment between taxable and non-taxable elements (such as compensation for pre-termination discrimination or injury to feelings). The FTT noted that the settlement payment had been made in a single, undifferentiated amount. Further, neither party had advanced evidence in support of apportionment (either in the form of witness evidence or evidence from an expert) and had not proposed a formula for how an apportionment should be made.
The UT decision
The UT upheld the decision of the FTT, essentially for the reasons it gave. The UT also accepted HMRC’s submission that Ms Morthy could not hope to dissociate the settlement payment from the termination in circumstances where she had within the settlement agreement taken the benefit of the £30,000 threshold in s.403 and the s.413A exemption in respect of a £400,000 payment for her legal fees.
The UT also dismissed an appeal against the FTT’s refusal to apportion the settlement payment between taxable and non-taxable elements in view of Ms Mathur’s failure to advance a positive case before the FTT.
Points to take away
- If the point was not obvious already, the decision in Mathur drives home the importance of risk management in the negotiations preceding settlement and within the terms of settlement themselves. If the employer is unwilling to provide a tax indemnity (as is typically the case), the employee should enter settlement with their eyes open to the possibility of a deduction for tax, either made by the employer at source or through a subsequent tax assessment. The employee should seek a settlement sum which reflects these risks so that any later tax deduction does not leave them feeling cheated or, worse still, poorly advised.
- Mathur also underscores the importance of apportionment in two respects.
- Firstly, where possible the settlement sum should be apportioned so that sums paid by way of non-taxable compensation (such as for pre-termination discrimination and injury to feelings) are clearly identified and quantified. Plainly, such apportionment must be credible and explicable with reference to the facts of the settled dispute.
- Secondly, if the employee seeks recovery of a sum deducted for tax through self-assessment, he or she must assert a positive case on apportionment, supported by evidence, especially where the original settlement agreement failed to apportion the settlement sum.
- Finally, the employee’s position should be presented consistently throughout. If the settlement agreement states in terms that the employee is taking the benefit of the £30,000 exemption, or is receiving a tax-free payment towards legal fees, such provisions will undermine a later claim that a settlement payment was unrelated to termination. Similarly, care needs to be taken in the presentation of claims to the employment tribunal if the incidence of tax on a later settlement payment is likely to become an issue.
