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The First-tier Tribunal (FTT) has confirmed that, where a payment is described as a 'payment in lieu of notice', it can be properly taxed as damages, rather than earnings, where there is no contractual right to make a payment in lieu of notice.
Often questions arise in relation to the taxation of termination payments. The general position is that payments considered to be part of an employee's earnings are subject to tax and national insurance contributions, and payments which represent damages for breach of contract are regarded as tax-free up to a threshold of £30,000.
In Phillips v Revenue and Customs, Mr Phillips was employed as a Finance Director under a contract of employment which provided for him to receive three months' notice of the termination of his contract. His contract contained no right for his employer to make a payment in lieu of notice. Mr Phillips entered into a settlement agreement with his employment, under the terms of which his employment was terminated and he received a substantial payment in lieu of notice.
The FTT's judgment
Much of the FTT's judgment focused on the timing of the payments, as Mr Phillips unsuccessfully argued that he ought to be able to allocate the payment across two tax years in order to avoid being effectively penalised for receiving the termination payment in a lump sum (as opposed to the tax treatment of the payment had he worked his notice).
However, the FTT determined that the payment made to Mr Phillips should not have been charged to tax as earnings, but rather should have been treated as damages. Accordingly, the payment should only have been charged to tax to the extent it exceeded the £30,000 tax-free threshold.
This is because, in the absence of a right on the part of the employer to make a payment in lieu of notice, the payment was rightly damages for breach of contract. However, in its determination, the FTT highlighted that the outcome may have been different if it was evident that the employment was terminated by mutual agreement, as opposed to at the employer's instigation.
Due to the uncertainty which sometimes arises in relation to the taxation of termination payments, employers are reminded of the importance of ensuring that settlement agreements contain robust indemnities in respect of further tax liabilities. Indemnities can, however, be difficult and costly to enforce. As such, getting the tax treatment wrong is likely to invite further scrutiny from HMRC.
Employers should therefore ensure they give due attention to the taxation of any payments made under settlement agreement, including, but not limited to, payments in lieu of notice.
Where there is no contractual right to make a payment in lieu of notice, an employer may be able to treat the payment as damages. However, employer need to carefully consider all of the circumstances, in order to assess the risk that the payment could be considered to be earnings instead. We would recommend seeking legal advice where there is any doubt as to the tax treatment of payments under settlement agreements.