Taxing issues - Case Round-Up: July 2015
In this month's round-up, Mark Shulman consultant solicitor with Keystone Law, looks at recent cases on how to treat tax when grossing up ET compensation awards and whether payments under settlement agreements were “earnings”.
Mark Shulman, Consultant Solicitor at Keystone Law
TAX Grossing up Had an ET correctly grossed up its award of compensation? No, said the EAT in [Hall v Durham County Council & Ors ]()UKEAT/0256/14/MC.
The Claimant was a teacher. In what the EAT described as "an astonishing tale", the Claimant would never be able to work again as a teacher. This was as a result of actions which "reflected very little credit on the Local Authority or the management of the school in which she was employed".
Having succeeded in various claims, the ET made a considerable award to the Claimant, in total £945,754, some of which was not taxable, but of which £885,754 represented the net sum after tax. It had to ensure that the taxable sum it awarded would, after deduction of tax, be such as to leave the Claimant with the £885,754 it had awarded. Accordingly it grossed up the sum, taking account of what it thought were the appropriate taxation bands. The total was just short of £1.4 million. However, the ET, having agreed to reconsider its Judgment, dealt with a number of arguments addressed to it by both parties about that Decision. It amended its Judgment in a number of respects and the total revised award came after that process to a sum just short of £1.25 million.
The Claimant's substantive appeal raised a discrete point as to the proper approach to be taken to calculating an award when grossing up is applied.
She appealed on the basis that an award of compensation to her had been incorrectly "grossed up" and that the effect of that was actually to produce in her hand after tax, a figure less than the ET thought was full and proper compensation. The ET had refused to revise its tax approach on reconsideration and proceeded to take each of the taxable heads of compensation it had identified and ask whether, if that sum were paid, what the amount of tax would be in respect of each head.
*Wrong approach *The EAT agreed that the ET had adopted a wrong approach. It explained the problem by an illustrative example. Suppose that a Claimant is entitled to be paid an award of £80 and suppose that the marginal tax rate applicable to that sum is 25%. What would be the tax on the £80 once paid? The answer would be £20 (that being 25% of £80). The payment to be made by the Respondent would therefore need to be £100 in order to satisfy a debt of £80. But, the payment actually due to be made to the Claimant in this example and on which tax is due is not £80, but £100 (an £80 award plus £20 tax on that £80). However, it is that £100 which is taxable. If tax at 25% is applied to the £100, the result is to leave £75. That is £5 less than the £80 to which the Claimant would be entitled. That demonstrated the error in the ET's approach.
What the ET had done it to ask itself what tax ("T") would be payable by the Claimant if a sum equal to the total compensation ("C") was paid to her, and added the amount of the tax to the intended award ("T + C"). Tax would be paid on that. The result would therefore be similar to the reduction to £75 from the £80 in the EAT's example. The result would be less than the compensatory sum that the ET had determined was appropriate - the sum paid free of (i.e. after) tax. As a matter of principle, whatever the sum payable to the Claimant may be, the taxable elements of it require to be grossed up not by applying the tax due on those elements in addition, but by assessing what sum will, when subject to taxation, produce that amount.
Accordingly, the Claimant's appeal was allowed in relation to the approach taken to grossing up.
Editor's note: If the net sum to be received by the Claimant is, say, £50,000, all of which will be taxed at, say, 25%, the gross amount to be awarded is 50,000/0.75 = £66,666.66.
Working forwards again, if the Claimant receives £66,666.66 and pays tax @ 25% on this amount she will receive 66,666.66 x 0.75 = 50,000 which is correct.
What the ET had done was to calculate 25% of £50,000 = 50,000 x 0.25 = 12,500 and then added it back on to get £62,500. But 25% of £62,500 = £15,625 so the claimant would end up with only £46,875.
The general rule is that if the Claimant should receive in her hand £x, and the marginal tax rate is y%, you divide £x by (1 - y%) to get the gross amount to be paid by the respondent.
Payments under a compromise agreement Was a payment of £30,000 made to an employee under the terms of a compromise agreement to be treated as earnings from employment or was the payment within the applicable exemptions within Chapter 3 of Part 6 ITEPA (which covers, inter alia, sums paid on the termination of employment)? The recent case of [Hill v Revenue & Customs ]() UKFTT 295 (TC) looked at these issues.
Chapter 3, Part 6 of ITEPA The £30,000 exemption referable to section 401(1) of the Income Tax (Earnings and Pensions) Act 2003 ("ITEPA") applies to "payments and other benefits" which are received directly or indirectly in consideration or in consequence of, or otherwise in connection with (amongst other circumstances) the termination of a person's employment. But that provision "does not apply to any payment or other benefit chargeable to income tax apart from this Chapter".
Background In an appeal to the First-Tier Tribunal Tax Chamber, Mr Hill challenged an amendment to his self-assessment return relating to the sum of £30,000 paid to him under the terms of a compromise agreement. His contract of employment with General Motors ("GM") provided that he was to be located at a specific office location (in Bedfordshire), but that he might be required to work at other sites within a 10 mile radius. Following a secondment to Saab City, he was subject to a TUPE transfer. However, Mr Hill was unhappy with the transfer of his employment to Saab City. 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 not happy about the prospect of continuing to work in London, which was a long way from home. He therefore raised a grievance with GM and Saab City and after a protracted period of negotiation a compromise agreement was entered into.
Settlement terms Mr Hill's view was that as the payments were made to him under a compromise agreement, they were not made in return for his services to either employer and therefore could not constitute taxable "earnings". HMRC argued that the payments were consideration for Mr Hill's agreement to continue to work more than 10 miles from his Bedfordshire base and were therefore attributable to Mr Hill's agreement to a change in a key term of his continuing employment contract. On that basis the payments would be taxable as emoluments.
The Tax Tribunal thought the compromise agreement was "not a model of clarity", but Mr Hill was to receive £15,000 from each of Saab City and GM in full and final settlement of all and any claims or rights of action that he had or may have had against either of them or any related company. It was a further provision of the compromise agreement that if Mr Hill were to cease to be employed by Saab City within 2 years from the date of payment (except in the case of redundancy or unfair dismissal), he would be required to pay back to GM and Saab City the amounts received under the settlement terms on a reducing sliding scale, depending on when he left the employment.
Did the £30,000 exemption apply? In order to be successful in arguing that the payments in question fell within Chapter 3 of Part 6 of ITEPA (i.e. within the £30,000 exemption), Mr Hill had to establish that the payments were received directly or indirectly in consideration or in consequence of, or otherwise in connection with:
* the termination of his employment; * a change in the duties of his employment; or * a change in the earnings from his employment.
The Tax Tribunal referred to the TUPE Regulations and pointed out that on the face of it, there had been no termination of employment because following the TUPE transfer, Mr Hill's original contract of employment with GM was to be regarded as having continued and Saab City in law stood in the shoes of GM. However, the First-Tier Tribunal in Kuehne & Nagel Drinks Logistics Ltd and Others v Revenue and Customs Commissioners ( UKFTT 379) had considered that the deeming language in the TUPE Regulations should be limited to its particular purpose and should not be taken into account in applying the tax legislation in ITEPA.
But in any event, the Tax Tribunal considered that the answer did not turn on the question of whether Mr Hill's contract of employment with GM was terminated and replaced by a new contract of employment with Saab City or whether Mr Hill's contract of employment with GM simply continued but on different terms. This was because, in either case, the payments were precluded from falling within Chapter 3 of Part 6 of ITEPA to the extent that they were subject to income tax apart from that Chapter and Part 2 of ITEPA imposed a charge to tax on "earnings" (i.e. "anything... that constitutes an emolument of the employment").
Were the payments emoluments? If the payments received by Mr Hill could properly be described as "emoluments" then they could not fall within Chapter 3 of Part 6 of ITEPA (under which the £30,000 exemption falls). At the hearing, Mr Hill conceded that, if he had simply received the payments as consideration for his agreement to work outside the 10 mile radius from the Bedfordshire office set down in his contract with GM, the payments would be taxable as emoluments falling with Section 62 of ITEPA. However, he contended that the answer should be different where, instead of being paid to agree to a change in the terms of his contract of employment, he was paid for agreeing not to pursue a claim for damages in respect of a breach of those terms.
The Tax Tribunal did not accept that distinction. Its view was that whether the payments were consideration for an agreement to accept a change in a particular term of his employment contract going forward or were consideration for agreeing not to pursue a claim for breach of that particular term in his employment contract going forward, the tax treatment should be the same. In both cases, the effect of the agreement between the parties was that Mr Hill was paid £30,000 and in return accepted that he could be required to work more than 10 miles from the Bedfordshire office following the transfer. There were a number of case authorities which had decided that a payment received by an employee in return for an agreement to a change the terms of their employment had been treated as constituting an "emolument" of the employment and therefore count as earnings for tax purposes. Specifically, in Kuehne & Nagel Drinks Logistics Ltd and Others v Commissioners for Her Majesty's Revenue and Customs ( EWCA Civ 34), the Court of Appeal held that amounts received by employees as compensation for agreeing to accept a reduction in pension rights following a transfer under the TUPE Regulations were taxable as emoluments. By analogy, in Mr Hill's case, payment of compensation was for a change in the terms of his employment contract and was to be characterised as an emolument from his employment.
Further, the conclusion about the tax status of the payments was reinforced by the terms of the compromise agreement which required Mr Hill to refund all or part of the compensation payments in the event that he ceased to be employed by Saab City within 2 years of the payment date. This supported the proposition that the payments were actually emoluments of Mr Hill's continuing employment.
Mr Hill's appeal was therefore dismissed "with some regret". It became apparent at the hearing that Mr Hill had gone through a difficult process in pursuing his grievance against his employers and that his willingness to accept the £30,000 that was paid to him was predicated on his belief that the sum would be free of tax in his hands. He might well have held out for more if he had known that he would be subject to tax on the payments.
Comment On its specific facts as set out in the judgment, it is difficult to see how the Tax Tribunal's decision could be successfully challenged. As the Tribunal itself pointed out, the position would have been different had there been no transfer under the TUPE Regulations and had Mr Hill been paid a sum by GM on the termination of his contract. In that case, there would clearly have been no ongoing employment to which the payments could be referenced. But the moral is clear for practitioners acting for employees in relation to settlement agreements where there is continuing employment: there is a greater potential risk of compensation sums being treated as emoluments and taxable accordingly. Specialist tax advice may be needed in these types of cases as clients will be expecting a specific sum in their hands after tax and will need to know their position in negotiations before settling their claims.
Salary or compensation? In another recent and interesting case before the First-Tier Tribunal Tax Chamber (Mr A v Revenue & Customs (Income tax/Corporation tax: Employment income), the issue was whether a payoff to a bank trader was designed to make good shortfalls in salary and bonus (and was therefore taxable), or whether the sum was tax free compensation in respect of the employee's threatened race discrimination claim.
*Background *The Appellant gave evidence that, although he was the most senior emerging markets trader at the Bank at the relevant time, he was not invited to apply for the role of Deputy in charge of the Emerging Markets Group when it became vacant. It went instead to someone else who had joined the Bank a few months earlier and as far as the Appellant knew, did not have knowledge of emerging markets trading. The Appellant also had to report to and pass his trades through a more junior colleague. He felt side-lined and was not from then on invited to investment meetings, client briefings or formal client events. There were also issues relating to the amount of the Appellant's annual bonus over several years.
Subsequently, following a buyout of the Bank, the Appellant was notified of imminent redundancies and he lodged a formal grievance concerning his apparent selection for redundancy and alleged unfair treatment by the Bank in connection with the amounts of his previous bonuses and pay.
He subsequently raised a further grievance relating to his bonus award for 2007, claiming that he was aware that even employees who sustained losses for the bank in 2007 received bonuses, yet he had received none. He maintained that it was because of his ethnic origin that he had received less favourable treatment.
The Bank's response following the grievances was that it "…found no evidence of less favourable treatment of you let alone on the grounds of your ethnic origin." The Appellant's solicitor served a questionnaire under the Race Relations Act 1976. It included a claim that the Appellant had been treated less favourably in relation to salary and bonuses and that this had been continuing since 2005. Following the questionnaire, the Bank informed the Appellant he was being made redundant and offered him £1,650 in statutory redundancy pay and an ex-gratia payment of £48,898. A couple of days later the Bank offered the Appellant an additional lump sum of £600,000 if he signed a Compromise Agreement.
*HMRC – why was the £600,000 paid? *HMRC asked the Bank for a detailed breakdown of what the £600,000 payment was for. The Bank's reply explained that it was a total settlement, negotiated first as €700,000 and then converted to sterling and rounded down to £600,000. The settlement was finalised without any allocation of specific amounts to specific parts of his claims. HMRC then made a further request asking the Bank to explain what elements of the claim the Bank considered to have merit and were capable of successful litigation. It also asked whether the Bank believed that the Appellant had any contractual entitlement to the £600,000 compensation payment. The Bank responded by expanding what factors had influenced their decision and concluded that "It is difficult to give definitive answers as this was a negotiated settlement to settle all possible claims, without specific apportionment…".
What are "earnings"? Section 62 of The Income (Tax Earnings and Pensions) Act 2003 ("ITEPA 2003") deals with "earnings":
"(1) This section explains what is meant by "earnings" in the employment income Parts.
(2) In those Parts "earnings", in relation to an employment, means-
(a) any salary, wages or fee,
(b) any gratuity or other profit or incidental benefit of any kind obtained by the employee if it is money or money's worth, or
(c) anything else that constitutes an emolument of the employment."
Was the settlement payment of £600,000 to be taxed as "earnings" or was the payment in respect of discrimination? A payment will be earnings if it is a reward for services past, present or future (Hochstrasser v Mayes .
Compensation calculated by reference to lost earnings The interesting question arose as to whether an award for race discrimination is taxable where it is calculated by reference to loss of earnings.
The Appellant's case was that the Bank made the payment of £600,000 in settlement of a claim for race discrimination and that the sum represented compensation for the Appellant's unfair treatment in receiving low or no bonuses over several years and no salary increases.
HMRC's case was that where damages for discrimination are awarded by reference to earnings (whether pre- or post termination of employment), then the amount relating to earnings is taxable. The Tax Tribunal could see no support either in principle or authority for HMRC's argument that damages payments which are calculated by reference to loss of earnings were taxable because "earnings are involved". However, the Appellant's view that such damages were not "earnings" was "equally bereft of authority".
The Tax Tribunal concluded that if an ET were to award damages for discrimination (whether calculated by reference to earnings or whether they included injury to feelings) such damages would be recompense for the right not to be discriminated against. They are treated in a like manner to a tort claim.
When the Tax Tribunal posed the question: "Why did the employee receive the payment?", the answer was not that it was in return for the employee's services, but because the employer had acted unlawfully by discriminating against the employee. Where damages are calculated by reference to under-paid earnings, those damages arise not because the employee was under remunerated, but because the under payment was discriminatory. An award in these circumstances could not in the Tribunal's view be described as a reward for services.
Settlement vs ET Order Did it make any difference that there was no order by an ET, but a payment made under a compromise agreement? No, said the Tax Tribunal. For tax purposes, compensation is treated the same whether it is paid as a result of the judgment of the court, or by settlement of a claim before judgment is given.
Was proof of actual discrimination required? Did the Appellant need to actually prove that discrimination actually took place? Again, no said the Tax Tribunal. It was only necessary to show that the money was paid to him in respect of the discrimination claim (whether or not it was a good one). He had only to produce sufficient evidence from which it may be inferred that the reason why the payment was made was to compensate him for an actual or potential action for discrimination. The Tax Tribunal's view was that the crucial element is that the payment was not a reward for past or future services, but for something else.
Whilst the Tax Tribunal was not required to effectively step into the shoes of an ET and consider whether there would have been a successful discrimination claim, it did need to be satisfied that the reason the payment was made by the employer (rightly or wrongly on their part) was to settle a discrimination claim and not to pay back money which they thought the Appellant was entitled to under his service agreement. It was therefore not necessary for the Appellant to show actual discrimination when there was at least some evidence from which inferences could be drawn as to why the payment was made. Accordingly, HMRC's approach of requiring the Appellant to show proof he was actually treated differently and that this different treatment arose because of his race, asked too much of him.
Reason for the payment The Tribunal considered that in order to understand what the £600,000 was for, it needed to consider what the parties said about the purpose of the payment, how they acted and their communications with each other. Having evaluated the evidence, it thought that the whole payment of £600,000 was made in respect of the claim for race discrimination which the Appellant had threatened to make. The Bank did not wish to defend such a claim and the payment was made to settle it.
Whilst parties making payments by way of settlement of actual or threatened legal proceedings may do so for a variety of reasons which are unrelated to the merits of the dispute, (e.g. the financial cost, opportunity cost in terms of the time and stress of others), it was not necessary to apportion what component of the payment related to merits of the discrimination claim and what related to any other of the various possible reasons. Such components only arose as a result of a claim.
Accordingly, the payment was not "earnings" under s62 of ITEPA, but a payment in respect of settlement of the Appellant's threatened claim for race discrimination and so not taxable as earnings.
Mark Shulman is a Consultant Solicitor with Keystone Law and an accredited workplace and employment mediator. His blog on new employment legislation can be found here.
Published: 11/07/2015 19:21