First-tier Tribunal (Tax)

[2010] UKFTT 288 (TC)

 

 

 

 

 

                                                                                                TC00577

 

Appeal number: TC/2009/13749

 

 

Income Tax – Termination Payment – Whether taxable as earnings or tax free Lump Sum – Compensation payment – Not Taxable – Appeal allowed

 

 

FIRST-TIER TRIBUNAL

TAX CHAMBER

 

 

 

                                                     N J WOOD                                    Appellant

 

 

                                                                      - and -

 

 

                                 THE COMMISSIONERS FOR HER MAJESTY’S

                                                   REVENUE AND CUSTOMS               Respondents

 

 

 

 

 

                                    TRIBUNAL:  DR K KHAN (Judge)

                                                             SHEILA WONG CHONG FRICS

                                                                                                                                   

 

 

Sitting in public in London on 4 May 2010

 

Bradley Thomas, Accountant, RHK Accountants, for Appellant

 

Nicola Parslow, Senior Officer, HMRC, for the Respondents.

 

 

© CROWN COPYRIGHT 2010

DECISION

 

Introduction

 

1.      The issue in this case is whether a payment of £37,424.29 made to the Appellant by his ex employer PSFM Limited after his contact had been terminated constitutes normal taxable emoluments as defined by Part 3, Chapter 1, Section 62 Income Tax (Earnings and Pensions) Act 2003 (“ITEPA”).  The payment was made pursuant to a Compromise Agreement entered into on 23 December 2004.

 

2.      The Appellant claims that the payment, referred to as a termination payment, is chargeable under the legislation at Part 6, Chapter 3, Section 401 Income Tax (Earnings and Pensions) Act 2003 and as such attracts the £30,000 exemption available.

 

3.      Mr Wood was employed by PSFM Limited from 4 February 2003 to 23 December 2004.

 

4.      The actual appeal which is dated 2 July 2009 is against an amendment to Self Assessment by Closure Notice, under Section 28A(1) and (2) of the Taxes Management Act 1970 for the year ended 5 April 2005.

 

The relevant facts

 

5.      The self assessment tax return of Mr Wood for the period 06/04/2004 – 05/04/2005 gives the following figures:

 

1.         Remuneration              £49,134

2.         Tax                              £14,170.80

3.         Lump Sum                   £37,424

4.         Exempt                        £30,000

5.         Taxable                       £  7,424

6.         Tax Deducted              £  8,233.38

        

6.      Under the terms of a Compromise Agreement Additional Payment (Clause 1.4) is a payment to Mr Wood of £37,424.49 his ex employer PSFM Limited.  This was made after his employment had been terminated but the payment was made net of basic rate tax and national insurance contributions which, according to the Agreement, “the Company is obliged to make at source”.

 

7.      Under the Compromise Agreement (Clause 2) Additional Payment was made “in full and final settlement of any claims which he has brought or could bring against the Company in relation to his employment or the termination of that employment including, in particular, any claims under statute, common law or European Union law or a redundancy payment or for remedies for alleged: unfair dismissal, wrongful dismissal, breach of contract, unlawful discrimination on the grounds of sex, religion or belief, sexual orientation or disability, unauthorised deduction from pay, non payment of holiday pay, or breach of the Working Time Regulations 1998.” 

 

8.      In a letter dated 9 October 2008, the employer states that the sum of £37,424.49 was made under the terms of the Compromise Agreement in respect of cash due to Mr Wood comprising £52,424.49 combining renewal/fund based commission.  The sum of £15,000 (difference between £37,424.49 and £52,424.49) is a retention which Mr Wood owed the Company. 

 

9.      The sum of £37,424.49, the additional payment, was treated as comprising of £30,000 as a termination payment which was exempt from tax, the remaining £7,424 as being taxable income.  The claim of £30,000 for this exemption from tax is under Section 401 ITEPA 2003.

 

10.    Under the terms of Mr Wood’s contract of employment he was paid a salary of £60,000 per year, as well as a discretionary bonus equal to up to 20% of that sum.  The discretionary bonus would not therefore exceed £12,000.

 

11.    The Respondents say that the £30,000 taxable under Section 62 ITEPA 2003.  This Section is a very broad based provision which taxes all earnings.  Earnings include payments that are received by virtue of the employment relationship including all remuneration for services.

 

The law

 

12.    The legislation, as it affects this case, is as follows:

 

         (1)     Section 50(6) Taxes Management Act 1970 places the onus of proof on the appellant to prove that the amendments and assessments appealed against are excessive.

 

         (2)     Section 62 ITEPA 2003 defines earnings in relation to an employment, as meaning

 

                   (a)     any salary, wages or fee, any gratuity or other profit or incidental benefit of any kind obtained by the employee if it is money or monies  or

                   (b)        anything else that constitutes an emolument of the employment

 

         (3)     Section 401 ITEPA 2003 deals with any payment or benefit received in consideration or in consequence with the termination of a person’s employment.

 

(4)     Section 403 ITEPA 2003 states that the taxable amount of a payment

received under this section is the extent to which it exceeds £30,000.

 

(5)     Regulation 37 Income Tax (Pay As You Earn) Regulations 2003 state that

          any relevant payment made after the employment has ceased is taxed at

          the basic rate of tax in force for the tax year in which the payment is

          made.

 

13.    Under Section 403-404 of ITEPA 2003, payments received after 5 April 1999 which are termination payments i.e. payments received in connection with the termination of a person’s office or employment qualifies for exemption from income tax if the payment can be brought into the charge to tax under Sections 401-416 ITEPA 2003.

 

14.    Under Statement of Practice 3/1996 HMRC has advised that where in a Compromise Agreement made at the termination of employment there is a restrictive covenant, such settlement sum will not be brought into tax in Sections 225 and 226 of ITEPA 2003.

 

The Appellant’s submissions

        

15.    The Appellant says that the payment was in compensation for loss of office.

 

16.    The Compromise Agreement states that the payment of £37,424.29 is paid subject to “the employer’s compliance with the Agreement” which is that he will not bring a claim against his former employee, as set out in Clause 2 of the Agreement.

 

17.    The Respondents’ argument is based on a letter from PSFM Limited and a note of a telephone conversation with the Finance Director Maya Batheja.  The Appellant’s say that she had very little involvement with his departure from PSFM Limited and was not present at the majority of the meetings in which the payment was discussed and, by her own admission “could not remember the circumstances” at that her comments were “based on her recollection of events”.  Her evidence is not reliable.

 

18.    An Appellant in entering into the Compromise Agreement has signed away his rights to make a future claim against his former employer and the payments are exempt by virtue of Section 401 ITEPA 2003 as claimed on the tax returns. 

 

The Respondents Submissions

 

19.    Respondents say that the £30,000 received by Mr Wood is taxable remuneration.  The Compromise Agreement is silent on the question of compensation.  Specifically it does not mention that the said sum was paid by way of compensation.

 

20.    The Respondents say that it is for Mr Wood to produce evidence that the nature and purpose of the payment was to compensate him for the loss of office or employment.  The Respondents draw the Tribunal’s attention to the absence of any documentation especially in the Compromise Agreement, to any payment under the heading of Compensation.

 

21.    They also said that the nature and quality of the disputed sum is that it is wholly a commission based payment and does not attract the £30,000 exemption.

 

22.    The Respondents say that the onus is on Mr Wood to show that the said sum of £37,424.49 lacked the nature of renewal/fund based commission and that a letter dated 9 October 2008 from Maya Batheja is wholly wrong.  In her letter, Ms Batheja hinted that the amounts paid to Mr Wood were “in respect of renewal/fund based commission less the sum of £15,000 which he owed to the company”. 

 

Conclusion

 

23.    There is a Compromise Agreement between the Appellant and his ex-employer dated 23 December 2004.  This is an Agreement inter alia, whereby the employee agrees to refrain from issuing or continuing proceedings under certain employment and other statutes.  It is normal for the employer to draft the Compromise Agreement, as in this case, and for the employee to receive independent advice as to the terms and effects of the proposed Agreement.  Since the employee agrees not to do something, namely not to commence or continue litigation, the Agreement includes a restrictive covenant. 

 

24.    A Compromise Agreement in this case contains Clause 2, Settlement of Claims.  As stated earlier, the Additional Payment which is made to the employee is made in settlement of “any claims which he has brought or could bring against the Company”.  Such claims arise in law.  The payment therefore allows the employee to accept a cash lump sum in return for giving up any claims he may have arising from his employment or its termination.

 

25.    The Inland Revenue have accepted generally that payments made pursuant to a Compromise Agreement, arising as it were from a separate agreement, and in settlement of claims, does not give rise to income.  It should not be automatically assumed that where such a payment is made the first £30,000 is such payment is free of income tax.  Each case depends on its facts.  For example, a £30,000 exemption does not apply to the extent that a cash sum paid to the employee is not in settlement of claims but rather it is consideration for services.

 

26.    The Inland Revenue have also accepted that payments made pursuant to a Compromise Agreement would not give rise to a tax charge where the employee enters into a restrictive covenant, as is typically case.  They have confirmed that where a payment has been made to an employee for entering into such a restrictive covenant, they will not seek to refuse a claim for the £30,000 exemption except in exceptional circumstances or if the payment being made is excessive.  (See HMRC notes EIM 03606SP 3/96.)

 

27.    In looking at Clause 2 of the Compromise Agreement, the Tribunal believes the lump sum payments made on termination of employment in this case did allow the first £30,000 to be tax exempt (ITEPA Sections 403 and 404) as the employee was not contractually entitled to the payments as they were paid in settlement of prospective claims which the employee may have against the employer under legislation.  The employee undertook no duties in return for that payment and received the payment not for acting as an employee.  The payment was therefore not general earnings within Section 62 ITEPA 2003.  The payment would be more akin to a termination payment within Section 401 IEPA that is under that Section. The payment will therefore be within the charging provisions (Sections 401-416 ITEPA 2003).  It will qualify for the £30,000 exemption since it is a payment in settlement of respective claims.

 

28.    The Tribunal has looked at the letter from PSFM (Maya Bacheja) of 9 February 2008.  In that letter it is stated that the additional payment (£37,424.49) made under the Compromise Agreement was in respect of cash due to Mr Wood in respect of commissions.  There are several points arising with regard to this letter.  The first is that the letter is four years after the event and seeks to recall facts with which the writer of the letter is not familiar. The second point is that a total amount of commission payable to Mr Wood under the terms of his Employment Contract is 20% of his salary of £60,000.  This is £12,000.  Thirdly, the Managing Director of the Company (Arthur Allison) was involved in the agreeing the Compromise Agreement in consultation with the Company’s lawyers.  The Tribunal therefore does not accept the letter of the 9 October 2008 as representing the true position and rejects the assertion that the payment made to Mr Wood was in respect of commissions arising from employment and therefore earnings.  It is more reasonable to assume that given the Compromise Agreement and the terms therein that the payments were made in settlement of prospective claims against the Company arising from litigation.

 

29.    The additional payments were made “net of basic rate tax and national insurance contributions which the Company is obliged to make at source” (Clause 1.4).  The Respondents assert that this is required pursuant to Regulation 37 Income Tax (Pay As You Earn) Regulations 2003 which state that any relevant payments made after employment has ceased are taxed at the basic rate of tax enforced for the year in which a payment is made.

 

30.    The fact that tax has been deducted at source does not mean that the Additional Payment does not qualify for the £30,000 exemption.

 

31.    It is normal practice when such payments are made, in particular if there is an argument, that the payments are exempt from income tax and that the £30,000 exemption, for the payroll department of the Company to contact the local PAYE Officer to confirm whether the payments should on the deduction of tax or not.  It appears that this was not done in this case.  Given that the Company used the services of a law firm to give advice in this matter, it is quite striking that this was not checked beforehand.  However, even if the payment is made to the employee tax free, the Compromise Agreement has made it clear that if Inland Revenue states that there is tax or national insurance payable then Mr Wood not the employer would be liable to make those payments (Clause 5).   The Company did not stand to be out of pocket if payments wee made gross.

 

32.    A prudent employer acting with proper legal advice would therefore always seek clearance from the local Tax Office and DSS office before making a tax free lump sum termination payment.  This was not done in this case.  However, the fact that it was not done is not conclusive that the payment should not have been made as an exempt payment without deduction of income tax.

 

33.    The Tribunal believes that the payment is in fact an exempt payment.  It does qualify to be made without deduction of income tax. 

 

34.    The Tribunal finds that the Appellant has discharged the requisite onus of proof to the required standard.

 

35.    The Tribunal also finds that HMRC should amend the self assessment form allowing £30,000 of the £37,424 to be made without deduction of tax and the remaining £7,424 to be taxable in the normal way.

 

 

 

 

 

DR K KHAN

TRIBUNAL JUDGE

RELEASE DATE: 25 June 2010