The First-tier Tribunal (the Tribunal) has held that a lump sum payment made to compensate an employee for the loss of pension, share and other contingent rights on the transfer of a business to a new undertaking was taxable only in part. The tribunal found that the payment was not made to induce the taxpayer to become an employee of the transferee and that the reasons for making the payment were dissociable. The compensation lump sum should therefore be apportioned between each lost right.
Under the Income Tax (Earnings and Pensions) Act 2003 (ITEPA), employees are liable to income tax on earnings “from” an employment. Section 401 of ITEPA imposes a charge to tax on payments made directly or indirectly in relation to a person's employment or a change in that person's duties or earnings, including, for example, payments made on redundancy. There is an exemption for the first £30,000.
The charge to tax on earnings (section 62, ITEPA) takes priority over the section 401 charge. HMRC's long-held view is that payments to employees to compensate for changes in terms of employment are taxable as earnings as deriving from the employment. In practice, HMRC argues that a payment to compensate for a variation in duties or earnings is made in return for the employee remaining as an employee, and, as such, the payment is taxable as earnings. The fact that it may also fall within section 401 of ITEPA 2003 does not help, since section 62 takes precedence.
The Tribunal (in Hill v HMRC ) has previously held that a payment to compensate the employee for a change in his employment terms was taxable as earnings. The Court of Appeal (in Hamblett v Godfrey (Inspector of Taxes) ) held that a compensation payment for the loss of a employment right to join a trade union, was taxable as earnings.
In Kuehne + Nagel Drinks Logistics Ltd, Stott and Joyce v HMRC , the Tribunal held that if a payment is made for more than one reason, and those reasons are not dissociable, the payment will be taxable if one of the substantial reasons for the payment is for being or acting as an employee.
If the payment is not made as an inducement to become or to remain an employee, but is made to buy-out a contingent right to a payment, the payment should be taxed in the same way as the bought out payment would have been taxed. This “substitution principle” arises from the decision of the House of Lords in Mairs v Haughey .
Under the Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE), on certain transfers of (part of) an undertaking, any of the transferor's employees assigned to that (part of the) undertaking are transferred to the transferee. The regulations provide that the transfer “shall not operate so as to terminate the contract of employment of any person employed by the transferor … but any such contract shall have effect after the transfer as if originally made between the person so employed and the transferee”.
Facts of the case
The taxpayer was employed by BP. By way of a TUPE transfer, BP transferred part of its business to S & J D Robertson North Air Ltd (North Air). As North Air's reward and benefit scheme was less generous than BP's a lump sum compensation payment, described as a “buy-out payment”, of almost £26,000 was negotiated. This was to compensate for loss of pension, bonus and share rights and loss of lunch allowances.
A framework agreement set out how compensation for each right was calculated, but a single lump sum payment was made. A loyalty payment was also separately negotiated, payable broadly on the first anniversary of employment with North Air, but was not, in fact, paid. Payment of the buy-out payment was conditional on the taxpayer complying with the terms of a compromise agreement: signing and returning the compromise agreement and entering into a new contract of employment with North Air. The compromise agreement confirmed that the buy-out payment was compensation for the termination of the taxpayer's employment with BP and for the taxpayer relinquishing access to the BP reward and benefit scheme. The compromise agreement also confirmed that the buy-out payment would be subject to deduction of tax and NICs “as may be required by law”.
The taxpayer treated the buy-out payment as falling within section 401 of ITEPA (and, being less than £30,000, exempt from tax) as a payment for loss of pension rights following the termination of his employment with BP. HMRC determined that the whole buy-out payment was taxable as earnings as being from the taxpayer's employment. HMRC amended the taxpayer's self-assessment return and the taxpayer appealed to the Tribunal.
The Tribunal allowed the appeal in part.
The Tribunal noted that the reason for the buy-out payment was to compensate for loss of pension, share and bonus rights and the loss of lunch allowances. That was clear from the evidence, most notably the compromise agreement. There was no evidence of any other reason for the payment. In particular, there was no evidence that the payment was made as an inducement to enter into employment with North Air or to accept different terms of employment. The Tribunal rejected HMRC's submission that the conditions set out in the compromise agreement were sufficient to make the payment an emolument of employment. The requirement to enter into an employment contract with North Air was not a reason for the payment but the trigger for the payment.
The Tribunal accepted that there were similarities between the facts of this case and those of Hamblett, but concluded that the payment in Hamblett was taxed as earnings because of an analysis of the lost rights, which in that case were employment rights directly connected with the fact of the employee's employment. In contrast, the lost rights in the present case were pension, share, bonus and lunch allowance rights. The tribunal analysed Hill in the same way.
As the sole reason for the payment was to compensate for the lost rights, rights that were contingent on the taxpayer remaining in employment with BP, the Mairs substitution principle applied. Accordingly, the tax treatment of the buy-out payment was determined by the tax treatment of the lost rights. Further, in contrast with Kuehne, the buy-out payment in this case comprised different components paid for different reasons and could, therefore, be apportioned between their constituent elements.
The tribunal disagreed with HMRC that there had been no termination of employment for tax purposes. Instead, it agreed with the Tribunal in Kuehne that while TUPE deems employment to continue for certain employment law purposes, it does not have the effect of deeming there to be a continuation of employment for tax purposes. In any event, the tribunal considered that the tax treatment of the buy-out payment did not turn on whether the employment was terminated or continued.
HMRC's long-held view is that payments to employees to compensate for changes in terms of employment are taxable as earnings as deriving from the employment. This decision illustrates that such a broad-brush approach is not right. The reasons for the payment must be carefully analysed and HMRC should not assume that payments are made in return for the employee becoming or remaining an employee if the evidence suggests otherwise.
The tribunal rejected HMRC's submission that the taxpayer's compliance with the terms of settlement agreement and, in particular, entering a new employment contract, was sufficient to make the payment an emolument of employment. Compliance was the trigger for the payment, not the reason for it. This illustrates the importance of recording the reasons for the payment in the settlement agreement.
The decision also highlights the very fine line between a payment being treated as taxable earnings or as buy-out payment taxed according to the nature of the payment it replaces. As the tribunal emphasised, the resolution is fact sensitive and a careful analysis of the reason(s) for the payment is required.