HMRC just tried to tax a discrimination payout. Whatever next!?

L v HMRC; pick your case...

For workers like contractors and consultants, its relevance is that it’s an FTT case concerning termination payments.

For headline-writers, it’s the conclusion of a case where the taxpayer managed to stay anonymous and keep out of the public eye.

For many others, it’s a case that will go down for showing how HMRC makes no bones about taking a discriminated-against party to court - even amid a court-verified suicide risk - if it thinks tax is due.

Whichever takeaway of it resonates with you, the case is L v HMRC [2024] UKFTT 001055 (TC), writes Naseerah Mussa, a consultant for employment law firm Chartergates.

What is L v HMRC about?

There are two cases of L versus HMRC at the First-Tier Tribunal (FTT) in 2024 (I will come to both), but it’s the second case - handed down in November 2024 - that is the focus of this article, exclusively for ContractorUK.

The relevant facts of the second case are as follows.

A taxpayer who worked as an executive director received a base salary, a discretionary bonus and long-term incentive plan awards. 

The taxpayer was made redundant in April 2013, and pursued claims against the employer including discrimination, unfair dismissal, unequal pay, and harassment. 

What did L’s payout by her employer cover?

In March 2014, a settlement was reached, and the employer paid the taxpayer a lump sum covering various aspects including: 

• Deferred compensation payment relating to the long-term incentive plan,
• Compensation for injury to feelings,
• Termination-related payment,
• Payments related to discrimination; and,
• Equal pay claims.

The settlement sums were made by the employer net of income tax and NICs on the basis that all but £30,000 of the total sums paid were subject to tax in accordance with Section 403 Income Tax (Earnings and Pensions) Act 2003 (‘ITEPA 2003’). 

When did HMRC first challenge L?

Following the settlement, L, the taxpayer rendered their 2014/15 tax return, but in 2017 HMRC opened an enquiry into the tax return.

HMRC issued a “Closure Notice” on May 10th 2021, that amended the taxpayer’s self-assessment return and determined that parts of the settlement payment related to the financial losses caused by the employer’s discriminatory actions and were taxable earnings under section 62 of ITEPA 2003. 

‘Damages, not earnings’

L challenged HMRC’s decision before the FTT, arguing that the settlement amount linked to her discrimination claim and constituted damages rather than earnings. 

A previous FTT hearing between L and HMRC (in May 2024) allowed the taxpayer to have the hearing heard privately and for the judgment to be anonymised on health grounds, as the court took account of the taxpayer’s bipolar condition and suicide risk.

Before the FTT in November 2024 in wake of HMRC’c Closure Notice, L argued that her employer’s payment compensated her for the loss of opportunity to work due to discrimination. The taxpayer’s position was that the payment was not a reward for her services to the employer. 

Therefore, it was contended whether it should be classified as taxable income under section 62 ITEPA 2003. 

L argued the payment mirrored compensation, typically, awarded by an employment tribunal which is not considered earnings from employment.

What was HMRC’s argument against L?

HMRC countered that the payments were based on the entitlements under her contract of employment, therefore, by default, making it taxable as earnings. 

In addition, HMRC stated that if a payment has both employment-related and non-employment-related purposes, it should be subject to tax if the employment part is a significant factor. 

What if an employer’s payout has multiple elements?

The FTT found that in cases where a payment has multiple elements, a non-employment-related reason, typically, will not negate the employment-related nature of the payment made to the individual. 

However, the FTT emphasised that this aspect needs to be considered in light of the specific and unique facts of each case. 

‘Lost opportunity’

In this particular case, L lost the chance to perform her role due to discrimination.

As such, it was found that the “lost opportunity” was not directly tied to employment, as she was unable to fulfil her role because of the discrimination she faced by her employer. 

FTT judge Amanda Brown KC accepted that while the payment would not have been made if the taxpayer had not been employed by her employer, applying the “but for” test was not sufficient in this case, to establish whether such a payment to the taxpayer should be taxed. 

‘Outside the scope of income tax’

To be taxed under section 62 ITEPA 2003, the payment must constitute a reward for the services provided -- which it did not, and therefore the portion of the settlement linked to the discrimination claim fell “outside the scope of income tax.”

Negotiating and agreeing a termination payment (and other implications of L v HMRC for workers)

Negotiating and agreeing a termination payment is an extremely complicated process in most circumstances, and so it requires very careful analysis.

In each situation, the precise nature of the payment should be considered with due regard for the application of the £30,000 threshold (and requirement for deduction of employer’s Class 1a NIC as of April 2020), as well as any exception from tax altogether that may be in point.

Failure to do so can have quite serious repercussions, given that HMRC can recover underpaid or unpaid tax and NIC, on top of penalties and interest from the person making the payment. 

Termination payments, discrimination claims, and employment contracts

In the case of L v HMRC, the question was whether a payment was ‘from employment’ and it’s a question that needs to be considered when there are multiple elements of a termination payment. 

For settlements concerning discrimination claims, as the case demonstrates, it is important to determine whether the payment was made in relation to the discrimination itself, or whether the payment relates to the amounts the employee is entitled to under their contract of employment.

And finally, some help if HMRC again tries to tax a discrimination payout…

At paragraph 97 of the FTT’s ruling, judge Brown helpfully offered a six-step approach to determining whether a payment made to settle a discrimination is taxable.

While consultants and other potentially affected parties are free to draw on those six steps, consult a trusted, established and qualified employment law firm for tailored contractual advice that you can rely on.