UK Courts Rule Against Tax-Free Termination Payments

by Jason Gorringe, Tax-News.com, London

13 August 2001

A recent UK case, HM Inspector of Taxes v Delaney, has substantially changed the tax regime for payments made to departing employees. For many years there has been a statutory concession that the first £30,000 of a termination settlement is tax-free; now, this will only be true in very limited circumstances.

Mr Delaney was told he was to be dismissed and not to come to work while his settlement was negotiated. Within a month, he received £75,000 and his company car as compensation. As usual, his employer paid out the first £30,000 of compensation tax-free. In the High Court, the Inland Revenue argued that because the payment was agreed and made while Mr Delaney was still employed, he should pay tax on all of it. The Revenue lost at first instance, but the Appeal Court reversed the judgement, saying that the concession should apply to what is truly a compensation payment for an employment that has already been lost.

Seemingly, employers could get around this judgement by firing people, then negotiating a settlement in which the employee gives up his rights to an action for unfair dismissal. The problem with this is that the employee has no certainty that the employer will negotiate in good faith, nor has the employer any certainty that the employee will accept the (perhaps already negotiated) settlement. Also, it is then on the public record that the employee was dismissed, while in the past the nature of the termination has been fudged into 'leaving' or even 'resigning' while the termination payment has been made tax-free regardless. In future that won't be possible.

Redundancy payments will continue to be tax-free, but dismissals are seldom redundancies (except for merchant bankers of course, who are regularly made redundant in downturns - like now - and then re-hired when things pick up again after two years). One prominent London legal practice said:

"The outcome of this decision is that it will be increasingly difficult to avoid tax on a termination settlement. In circumstances where the employer comes to an agreement that the employee will leave their employment, compensated by a sum of money, the payment will be taxable. Only where the employer is already in breach of contract, and the subsequently negotiated sum is paid as damages, will the tax exemption be available."

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