Deciding whether a payment is a termination payment or a restrictive covenant
By Justine Riccomini, Head of Tax (Employment and Devolved taxes)
27 January 2023
Justine Riccomini outlines what happened when a termination of employment settlement agreement relating to a restrictive covenant payment arrived before the First Tier Tax Tribunal.
Tax cases relating to termination payment settlements are not as common as they used to be. This case, known as “Mrs A v HMRC” was heard at the First Tier Tribunal and the decision was issued at the end of 2022.
Background
HMRC issued a closure notice to Mrs A in respect of a claim she had made in her 2018-19 tax return that would have resulted in an overpayment of tax amounting to £467,684. The claim was reduced to £6,136. Therefore, the appeal to the FTT involved a considerable sum of money (£461,548).
Mrs A had received a termination settlement amounting to £1,055,000 in May 2018 in return for her agreement to discontinue a claim to the Employment Tribunal and respect confidentialities. HMRC considered that the settlement was taxable under sections 401(1) 403(1) of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003), allowing for the first £30,000 to be exempt from taxation. Mrs A argued that the payment received was not connected to the termination of her employment but was made in return for her agreement to respect the confidentialities.
HMRC then argued that if the sum received did not represent a termination payment, it must represent a restrictive covenant as Mrs A’s conduct or activities were being fettered by the settlement agreement which she had signed. This would make it chargeable to tax under s.225 of ITEPA 2003 instead. Mrs A agreed that a restrictive undertaking had been signed up to but that it was nothing to do with her employment.
What was the court being asked to resolve?
Two issues required consideration, these were:
- Whether the settlement value represented A) a termination payment, or B) a payment in return for agreeing not to do something (this could be not to pursue an Employment Tribunal claim or not to disclose confidentialities); or
- If the payment was deemed to be B), whether this represented a restrictive undertaking taxable under s.225 ITEPA 2003.
Deliberations
When the employer did not uphold Mrs A’s original grievance, the decision also contained a request to respect confidentiality. Mrs A sought advice on the matter from a professional adviser and commenced proceedings at the Employment Tribunal. The adviser had covered the notional charges to tax under both s.401 and s.225 ITEPA 2003, should a termination of employment occur, but Mrs A argued that at that stage, she had not considered leaving the employment, so the settlement agreement which was being proposed did not relate to her termination of employment at that time. However, after that, Mrs A decided that she was unable to carry on working for the employer due to the stress of it all and agreed to leave. Her lawyer agreed on a settlement figure of £1.1m under the provisions of a settlement agreement.
Mrs A suffered the substantial tax deduction noted above and wrote to HMRC to ask whether the tax treatment had been correct. She believed that the payment was not compensation for loss of employment, but rather, for injury to feelings – however under s.406 ITEPA 2003, injury is only exempt if it is classed as psychiatric and injury to feelings is not exempt. She then completed her self-assessment return to show an overpayment. HMRC opened an enquiry into the return and concluded that s.401 ITEPA should apply to it. As this would mean the first £30,000 would be exempt, she could only claim an overpayment of £6,136.
Several key sections of the settlement agreement were relied on by the FTT to assist them in reaching their conclusions, as well as numerous other tax cases on termination payments, each of which has a distinct fact pattern, but which enabled the judiciary to conclude that section 401 was widely drawn as it states: “or otherwise in connection with an employment”.
Conclusions and decision
The FTT concluded: “In our view, it is clear from the terms of the Settlement Agreement that the payment was, at the very least, in consequence of or otherwise connected with the termination of Mrs A’s employment.” However, this was a secondary consideration. The FTT also concluded that the primary decision had to be that the payment must have come under the charge to tax at s.225 ITEPA 2003 (and be taxable in full).
Statement of Practice 3/96 determines that if a specific payment is made in return for an agreement not to pursue an employment claim via the Employment Tribunal, it should automatically qualify as a restrictive covenant payment under s.225 ITEPA 2003. The Tax Tribunal chose to note that a Statement of Practice is merely an HMRC interpretation and has no legal force – but came to the same effective conclusion independently from its review of the settlement agreement clauses which repeatedly referred to restrictions being the main reason for the payment, that s.225 should apply anyway.
The FTT concluded: “There is no doubt that an agreement not to pursue claims or proceedings is a restrictive undertaking within the scope of section 225.” They went on to conclude at paragraphs 63 and 64 of the decision: “It was paid…in respect of the restrictive undertaking given by Mrs A that she would not make or pursue any claims against the Employer and/or the Owner relating to or arising out of her employment or its termination. Accordingly, we find that the Compensation Sum is chargeable to tax as earnings from employment under section 225(3).
That conclusion is sufficient to determine this appeal but, in case we are wrong, we consider whether the payment was received by Mrs A ‘directly or indirectly in consideration or in consequence of, or otherwise in connection with’ the termination of her employment and is therefore chargeable to tax as employment income, to the extent that it exceeds £30,000, under section 403(1).”
The FTT decided that the settlement could not be apportioned into different elements because it was clear that it was received primarily as a restrictive covenant and derived from employment. The appeal was dismissed and leave of appeal granted, to expire within 56 days.
Final thoughts
As the amount Mrs A received was deemed to be wholly taxable under s.225, technically speaking this negates the residual overpayment of £6,136 originally allowed by HMRC when they concluded the payment fell within s.401 ITEPA 2003. If HMRC acts upon this FTT decision and disallows the overpayment, Mrs A will be worse off than if she had accepted their original decision
If you wish to contribute to the debate…why not join an ICAS tax committee and bring your expertise straight to the Tax team?