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In a recent decision, the First-tier Tax Tribunal (the tribunal) considered the correct tax treatment of a lump sum payment made to compensate an employee for the loss of certain benefits.
The tax treatment of the benefit that is being lost is highly relevant to whether such payments are subject to tax as 'earnings'.
In Reid v HMRC, Mr Reid worked for BP and was entitled to a variety of benefits including enhanced pension rights, share rights, bonus rights and (possibly) a lunch allowance (the benefits).
In 2010, BP announced that the part of the business in which Mr Reid was employed was to be transferred to another company, North Air. Mr Reid's employment would therefore also transfer by virtue of the Transfer of Undertakings (Protection of Employment) Act 2006 (TUPE) to North Air.
Under TUPE, Mr Reid's terms and conditions were protected. However, North Air's benefit scheme was not as generous as BP's. BP offered to make a payment (the settlement payment) to Mr Reid and other transferring employees in order to 'buy out' his right to the benefits. The employment offered by North Air would then be on less favourable terms and conditions.
Mr Reid agreed to this and entered into a settlement agreement recording the agreed terms. It was recorded that the calculation of the settlement payment was directly linked to the loss of Mr Reid's entitlement to the benefits (albeit that some information regarding the calculation was not available to the tribunal). In exchange for the settlement payment, Mr Reid agreed to settle any claims in respect of the benefits and enter into a new contract of employment with North Air.
The settlement payment was charged to tax under section 401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) which meant that the settlement payment was paid tax-free as it was less than £30,000.
HMRC challenged the tax treatment of the settlement payment, arguing that the settlement payment was taxable as 'earnings'.
The tribunal was satisfied that the settlement payment was made solely to compensate Mr Reid for the loss of the benefits, contingent of his further employment by BP. This engaged was is referred to as the 'replacement' principle, meaning that a compensation payment made in these circumstances should generally be taxed in the same way as the benefit being lost.
With this in mind, the tribunal concluded that the element of the settlement payment which they could decipher as being made to compensate Mr Reid for the loss of his contingent pension rights should not be subject to tax. In relation to the rest of the settlement payment, as they had insufficient evidence to assess the payments, they concluded that it should be taxed as earnings.
This case demonstrates that the tax tribunals will undertake a very careful analysis of the reasons why payments have been made to compensate employees in these circumstances. It is also important to stress that cases in this area are extremely fact-sensitive.
The case is also a useful illustration of the way in which employers can get around the protection which TUPE provides to employees in relation to the preservation of their terms and conditions through the use of a properly drafted settlement agreement. When drafting a settlement agreement, an employer should carefully consider how the compensation payment is made up and how each element of a payment should be treated for tax purposes.