24 January 2023
The complex rules that apply to termination payments can often lead to disagreements with HMRC regarding the tax position. The recent tax tribunal case of Mrs A v HMRC looked at how compensation for non-disclosure is treated.
In the first-tier tribunal case of Mrs A v HMRC, Mrs A signed a settlement agreement with her employer under which she received a ‘Compensation Sum’ of £1,055,000. This payment was compensation for the termination of her employment in May 2018 and was paid on the condition that she would be bound by certain confidentiality and non-disclosure obligations. Broadly speaking to help ensure that the circumstances and events leading up to the cessation of her employment were not made public.
The employer treated the Compensation Sum as being connected with the termination of her employment and taxed it under Section 401 of the Income Tax (Earnings and Pensions) Act (ITEPA) 2003, treating the first £30,000 as tax free and taxing the balance under PAYE.
However, in her 2018/19 tax return, Mrs A claimed a repayment of overpaid tax totalling £470,000 in relation to the Compensation Sum. This claim was made on the basis that Mrs A believed the payment was not taxable at all. HMRC disagreed and did not make the refund.
Mrs A appealed, claiming that the payment wasn’t connected with the termination of her employment. Mrs A’s argument was that the payment was completely related to her entering into the confidentiality and non-disclosure agreements (not the termination of her employment) and that it was not taxable as a restrictive covenant payment under Section 225 ITEPA 2003 either because the confidentiality and non-disclosure obligations did not restrict her conduct or activities in relation to her employment.
What happened in the tax tribunal hearing?
The tribunal dismissed Mrs A’s appeal. They concluded that the confidentiality and non-disclosure obligations were restrictive undertakings for tax purposes, and rejected Mrs A’s argument that the restricted actions had to relate to an employment.
As these undertakings were given in connection with Mrs A’s employment, it didn’t matter whether they affected Mrs A’s conduct or activities in respect of an employment or personally, the payment was taxable as a restrictive undertaking regardless.
Interestingly, the tribunal also went on to say that if the Compensation Sum wasn’t taxable as a restrictive undertaking, it would in any event be taxable as a termination payment under Section 401 ITEPA 2003 on the basis that there was a connection between the payment and the termination of Mrs A Employment.
Why is this case important?
This decision in this case is important because:
- It deals with the issue of compensation for non-disclosure and confidentiality, which is becoming more prevalent;
- It confirms that non-disclosure obligations such as this can amount to a restrictive undertaking for tax purposes if they are given in connection with an employment;
- It confirms that the exact nature of the payment must be established, and highlights the step-by-step order in which such payments need to be considered. In this case the rules on restrictive covenants took precedence over the termination payment rules, which is in accordance with HMRC’s guidance within their Employment Income Manual at EIM12810; and
- during the tribunal hearing HMRC’s view was that the payment was taxable under Section 401 ITEPA 2003 meaning they thought the first £30,000 was exempt from tax. However, the tribunal found that the payment was taxable in full under Section 225 ITEPA 2003. The implication therefore is that the whole of the sum received was taxable as a restrictive covenant and that the £30,000 exemption for termination payments did not apply. The interaction with HMRC Statement of Practice 3 (1996) was not considered by the tribunal as this is a Statement of Practice which has no force of law.
What should employers do?
Employers need to consider the implications of this case when Settlement Agreements are agreed to.
At this stage it is unclear how HMRC will interpret this decision, and whether they will cease to apply Statement of Practice 3 (1996) in the future. This adds further confusion and uncertainty to the tax treatment of Settlement Agreements which include such clauses and where a single Compensation Sum or similar is paid.
If you have any questions about this case or the tax treatment of termination payments, please contact Lee Knight or Susan Ball.