SolvedEIM12965 | Termination payments and benefits: statutory compensation for discrimination and compensation for hurt feelings
From HM Revenue & Customs · Employment Income Manual
This page has recently been updated. The previous text is available at EIM12966.
Where an individual is discriminated against, harassed, or victimised by an employer they may have a right to compensation from their employer under the Employment Rights Act 1996 or other statutory provisions.
An individual may receive compensation:
Compensation may be paid by the employer in respect of several different elements, such as for loss of earnings, injury, or injury to feelings. Each element needs to be considered separately and the general approach outlined at EIM12810 should be followed (see below).
Where an employee enters into a settlement agreement with their employer, best practice is for the agreement itself to set out what each element of the termination payment relates to. If there is no such attribution - such as where a single, non-divisible compensation payment is made by an employer “in settlement of all claims” - the facts need to be examined and a reasonable apportionment agreed as to the amount of compensation paid for different elements. If the agreement relates in part to termination of the employment, the onus will be on the taxpayer to show that the payment is not connected to the termination.
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Application of Sections 62, 225 and 394 ITEPA 2003
First of all, check whether any elements of the payment are taxable as earnings from the employment as defined at s62 ITEPA 2003. This will apply to any accrued holiday pay, bonuses, and some Payments in Lieu Of Notice (see EIM12975 onwards).
Section 62 may also apply to any payments in respect of amounts which the employee would have been entitled to but for discrimination. In Pettigrew v HMRC (2018 TC 06473) a part-time judge received compensation for unequal pay because he had been underpaid compared to full-time colleagues. Applying Mairs v Haughey (1993 BTC 339), the First-Tier Tribunal found that the compensation should derive its character from the nature of the payment it replaces (which would have been an emolument from the employment) and was therefore earnings.
The same treatment would apply to other types of discrimination. If a female employee had been underpaid relative to a comparable male colleague then any resulting compensation for the historic loss of earnings would be taxable as earnings from the employment (however, compensation for the distress caused by this discriminatory treatment might not be taxable – see below).
An element of the payment may be consideration for entering into a restrictive undertaking (such as a non-compete or non-disclosure arrangement). Such payments are treated as general earnings under s225 ITEPA 2003 (see EIM03600 onwards).
If the payment is made on or in anticipation of retirement it may constitute a “relevant benefit” under an employer-financed retirement benefits scheme (EFRBS) in which case it will count as employment income under s394 ITEPA 2003 (see EIM15010 onwards).
If there is no other charge to Income Tax - bearing in mind that the list above is not exhaustive - consider s401 ITEPA 2003.
Scope of section 401 ITEPA 2003
In cases involving discrimination, a payment made under a settlement agreement might represent:
loss of future earnings
historic losses
injury
injury to feelings
Section 401 ITEPA 2003 will apply if the payment is “connected with” (see EIM13012) the termination (or a change in duties or earnings) of the employment. Each element of the payment must be considered separately.
Application of s401 ITEPA 2003: loss of earnings
If compensation for discrimination represents loss of future earnings (after termination of the employment) then that compensation is clearly connected with the termination and s401 will apply. This is the case even where discrimination has led to the termination of the employment, or where the termination itself was discriminatory; there is the necessary connection to the termination for s401 to apply.
On the other hand, if the payment is for a “historic” loss - as in the previous example involving gender discrimination and unequal pay - then there is no connection to the termination of employment and s401 will not apply (but s62 might).
Application of s401 ITEPA 2003: injury
The employer may be required to pay compensation if its actions have caused a mental health condition such as stress, anxiety or depression that affects the individual’s ability to work.
Such compensation is connected to the termination of the employment because it arises from the end of the employment (and the inability to take up similar employment elsewhere). It is therefore within the scope of s401, but may qualify for the exemption for payments made in respect of injury to or disability at s406(1)(b) ITEPA 2003.
Compensation for injury should be handled in the normal way (see EIM13610 onwards). To qualify for exemption under s406 the condition must prevent the employee from carrying out the duties of the employment, and medical evidence must be provided.
Application of s401 ITEPA 2003: injury to feelings
In addition to the financial losses described above, the employer may pay compensation for the distress caused by its actions. This is known as compensation for injury to feelings.
If this element of the payment can reasonably be attributed solely to discrimination occurring before the termination of employment, it should be accepted as not connected with the termination and outside of the scope of s401.
The Special Commissioners’ decision in Walker v Adams (SpC344) illustrates this. An individual accepted £77,446 as compensation after suffering constructive dismissal based on religious discrimination. This comprised £12,500 for injury to feelings and £64,947 in respect of loss of earnings. The £64,947 element was taxable under s148 ICTA 1988 (now s401 ITEPA 2003) because it was connected to the termination of the individual’s employment. HMRC accepted that the £12,500 was not taxable on the basis that the Commissioners had found that all discrimination took place pre-termination.
In other circumstances, a payment for injury to feelings may be sufficiently connected to the termination to come within the scope of s401. Taxpayers may cite the case of Oti-Obihara v HMRC (2011 TC 00819) in which the First-Tier Tribunal found that s401 does not apply to compensation for non-financial losses. However, the Court of Appeal in Moorthy v HMRC (2018 EWCA Civ 847) indicated that the ‘Oti-Obihara’ case was wrongly decided by reference to an incorrect statutory test and should not be followed.
In Moorthy v HMRC, the termination itself was discriminatory (and there had been no previous discrimination during the employment) so all of the compensation fell within s401 (despite being within the scope of s401, the amount that could be attributed to injury to feelings was exempted under provisions which have now been amended).
Where the termination is discriminatory but there has also been discrimination during the employment, the facts need to be examined to determine what a payment for injury to feelings relates to. The payment can be apportioned if necessary.
The Court of Appeal’s decision in Moorthy v HMRC discusses the amount of compensation that can reasonably be attributed to injury to feelings. The decision confirmed that such payments should be proportionate to the ‘Vento’ guidelines (see Vento v Chief Constable of West Yorkshire Police [2002] EWCA Civ 1871), which provide an indication of the amount that would have been awarded had the discrimination claims been settled at an Employment Tribunal. On that basis, the Court found that only £30,000 of the £200,000 paid to Mr Moorthy could be attributed to injury to feelings.
At para 79 of the decision, the Court indicated that taxpayers should not attempt to obtain exemption for much larger sums under the guise of a settlement of a discrimination claim. Where a payment is made as part of a settlement or compromise agreement, the amount attributed to injury to feelings should still be proportionate to the Vento guidelines.
The Vento guidelines are uplifted from time to time (most recently in April 2021). HMRC will look to apply the guidance in force at the date the settlement agreement is signed.
The ‘Walker’ and ‘Moorthy’ cases are both examples of a reasonable apportionment being made between compensation for loss of future earnings (which is taxable under s401) and compensation for injury to feelings (which may not be taxable if it is not connected to the termination of the employment).