Compensation received by an employee to settle a discrimination claim is not taxable as earnings, a tribunal has ruled.
A v The Commissioners for HMRC involved a dispute over whether a payment of £600,000 made under a compromise agreement should be taxed as “earnings” or whether it could be paid tax free.
The employee worked as a trader for a European bank and was entitled to be considered for a discretionary bonus based on achievement of personal sales and business development goals.
From the start of his employment he raised concerns with his employer that his bonuses did not reflect the profits he had generated and were lower than the bonuses awarded to other employees.
By late 2007 the bank was proposing redundancies. At this point the member of staff in question raised a grievance of race discrimination in relation to his pay and bonuses.
His employment was later terminated and a settlement agreement entered into, under which he received a payment of £600,000 (plus payments on account of redundancy) in full and final settlement of all claims.
But HM Revenue and Customs (HMRC) argued that this payment related to underpaid bonuses from past years. As these bonus payments would have been taxed as earnings, any compensation paid should also be treated as earnings, thus taxable at his marginal rate.
However, the tax tribunal disagreed with HMRC because there was no authority that damage payments calculated to a loss of earnings are themselves necessarily taxable as earnings.
The tribunal found that the employer had paid the compensation to settle the race discrimination claim threatened by the employee, even though there was no suggestion that the employee intended to pursue a claim for breach of contract.
Compensation awarded by a tribunal in relation to a race discrimination claim would have reflected the fact that the employer had breached its statutory obligation not to discriminate.
The fact that such compensation might be calculated by reference to lost income did not mean that the compensation should be treated as a reward for services and therefore taxable as earnings.
Elizabeth Slattery, employment partner at law firm Hogan Lovells, said: “HMRC did not seek to argue that the payment should be taxed as a payment on termination of employment.
“The events giving rise to the race discrimination claim had clearly taken place over a long period prior to the taxpayer’s dismissal and the taxpayer had complained about those events at the time.
“As such, the wide powers to tax a payment made in connection with termination of employment did not come into play.”