Back in 2014, Moorthy v. HMRC was a hot case looking at the taxable status of payments to employees for injury to feelings caused by unlawful discrimination. Historically there had been an unspoken understanding that such compensation could be paid tax free, on top of the usual £30,000 allowance for termination payments.  However, the First Tier Tax Tribunal concluded that compensation for injury to feelings would only be tax-free if it did not arise “directly or indirectly in consideration of or in consequence of the termination of a person’s employment“.  If it was related in some way to that termination (most obviously through a dismissal being found to be discriminatory) then it would only be tax free to the extent that it and all the other compensation payments made added up to less than £30,000.

That decision has just been upheld by the Upper Tax Tribunal. It seems unlikely to be further appealed, so we had better get used to what that means for the structuring of severance payments and the drafting of settlement agreements:

Lessons for employers

Let us assume for these purposes that as employer you can get past the irritation implicit in paying tax-free cash to an ex-employee for injury to his feelings caused by an act of discrimination which you probably deny ever took place. Instead, let us proceed on the premise that you want to pay injury to feelings compensation tax-free if possible so as to minimise the cost to you of providing an acceptable level of return to the employee.  On that basis, consider:

(i) within the settlement agreement, identifying expressly the (alleged) acts of non-termination discrimination and attributing a separate injury to feelings figure to them;

(ii) if the termination is also alleged to be discriminatory, attach a separate injury to feelings figure to this also;

(iii) there is no reason in logic why there should not be payments for both pre-termination and termination-related injured feelings in the same settlement, but remember the relativity of the two sums.  HMRC may view with some suspicion a larger payment for injury to feelings caused by pre-termination discrimination than for an outright dismissal which will on any view usually cause the greater distress.  Such an imbalance may suggest that the employer is shifting compensation which is actually for the dismissal, and so potentially taxable, into the tax-free pre-termination piece, an assessment HMRC would not be shy to challenge;

(iv) and also keep an eye on the size of the pre-termination injury to feelings amount relative to the act of discrimination it is paid for.  A failure to follow the Vento guidelines (e.g. paying more than about £6,000 for minor one-off acts or over £18,000 for anything less than the most serious and extended harassment) would also allow HMRC to challenge the status of the payment.  The employee will also have to tread a thin line here – the more serious the pre-termination discrimination alleged, the less easily HMRC will accept that it did not play some role in the subsequent parting.  However, the point is still entirely arguable in the right circumstances – an employee subjected to very serious harassment whose whole workplace is closed while his claim is still unresolved, for example.

(v) make sure that any tax indemnity in the settlement agreement covers not just the ordinary severance payment but also the injury to feelings amount(s);

(vi) and finally as employer, note that HMRC will look askance at tax-free injury to feelings payments on termination which purport to be for acts of discrimination taking place any material time before the dismissal.  Ideally there would be evidence of an ongoing grievance or Employment Tribunal claim still extant at the time of the dismissal.  The obvious point is that if the pre-termination discrimination was long ago or had clearly not become an issue of contention, a sudden payment of compensation for it will inevitably look contrived.  Equally, of course, the closer the alleged discrimination is in time to the termination, the less keen HMRC will be to accept that it is actually unrelated to it.