Termination payments: don't forget the breakdown
In an encouraging win for taxpayers, the First-tier Tribunal ('FTT') in Johnson v HMRC[1] allowed an appeal relating to a termination payment under a compromise agreement.
It did so notwithstanding its decision in Reid v HMRC[2], a case with similar facts (indeed even involving another director of the same company), in which it found in favour of HMRC.
The facts
Mr Johnson had been sales director of Richardson Social Housing Limited (the 'Company') for about two years when in December 2007 he agreed to leave with immediate effect. His employment contract required 6 months' notice to be given by the terminating party, and contained no provisions permitting payment in lieu of notice.
About a month later, Mr Johnson entered into a compromise agreement (the 'Agreement') under which the Company agreed to pay him £75,700 "less any income tax or other sum the employer is required by law … to deduct" (the 'Termination Payment'). The Agreement stated that the Company "agrees not to make any deduction from the first £30,000 of the Termination Payment on the basis that the parties believe that under normal HM Revenue & Customs Rules, the first £30,000 … of the Termination Payment may be paid to the Employee tax free". Otherwise, the only other breakdown of the constituent parts comprising the Termination Payment was a statement that it "includes the employee's entitlement if any to a Statutory Redundancy Payment in the sum of £930". The Agreement contained an entire agreement clause.
Mr Johnson was paid the Termination Payment and later completed his self-assessment tax return for 2007/2008. Mr Johnson's return omitted £30,000 of the Termination Payment on the basis that under section 403 of the Income Tax (Earnings and Pensions) Act 2003 ('ITEPA') it was not subject to tax. He later amended his return by omitting a further £30,000 of the Termination Payment, leaving his taxable income at £15,700. He did so on the basis that this further £30,000 represented a refund under a nil-cost Enterprise Management Incentive ('EMI') option he had purchased when he joined the Company and was therefore not taxable income. HMRC opened an enquiry into Mr Johnson's return and later demanded tax in relation to the further £30,000 omitted from his amended return, which tax amounted to approximately £12,000. (HMRC originally sought £12,000 plus a 10% penalty, but they later revised this down to £11,628 and did not seek a penalty.)
Mr Johnson's position
Mr Johnson contended that the Termination Payment comprised the following:
- £44,770, which was a non-contractual termination payment falling within section 401 ITEPA and, as a result, £30,000 of this payment was not subject to income tax;
- £30,000, which was a repayment of his EMI option scheme payment and, again therefore, was not subject to income tax; and
- £930, which was a statutory redundancy payment.
In support of A. above, Mr Johnson argued that this non-contractual termination payment equalled his salary (£6,866.67) plus his car allowance (£595) for six months: (£6,866.67 + £595) * 6 months = £44,770.02. However, he contended that this was not a contractual payment in lieu of notice (at least in part because his employment contract contained no such provisions) and, accordingly, was not subject to income tax under section 62 ITEPA.
In support of B. above, which was in the end the key point in dispute, Mr Johnson's argument was essentially twofold:
- First, he relied upon documents which he contended proved that he had made the £30,000 investment in the EMI option scheme when he joined the Company (including mortgage documentation showing borrowings to fund the investment).
- Secondly, he claimed that, had the Termination Payment not comprised a repayment of his £30,000 EMI investment, he would not have entered into the Agreement.
To evidence the latter, he pointed to cogent evidence outside of the Agreement which he claimed proved the point. This included a solicitor's letter and HMRC guidance. Although the judgment does not specifically refer, it follows from this that Mr Johnson essentially contended that HMRC could, and should, look beyond the Agreement despite its entire agreement clause to ascertain the real constituent parts of the Termination Payment.
HMRC's position
During correspondence regarding Mr Johnson's self-assessment tax returns, HMRC accepted Mr Johnson's assertion that the Termination Payment included 6 months' wages and car allowance. Despite this, they concluded at the time that this was not a non-contractual payment; rather, it should be treated as payment in lieu of notice and taxed under section 62 ITEPA. However, at the appeal hearing HMRC accepted Mr Johnson's argument and accordingly conceded that £30,000 of the Termination Payment was a non-contractual payment which was not subject to tax by virtue of section 403 ITEPA.
However, HMRC claimed that the remaining £44,770 of the Termination Payment was taxable and did not accept that £30,000 of this sum represented a refund of Mr Johnson's EMI payment. HMRC pointed to the entire agreement clause in the Agreement and argued that, in line with Reid, they could look only to the Agreement to interpret what constituent parts made up the Termination Payment and were precluded from looking at the wider circumstances.
The FTT's decision
The FTT noted that HMRC was not a party to the Agreement and accordingly held that they could not rely on the entire agreement clause. Accordingly, HMRC were obliged to look at the surrounding circumstances in determining the nature of the Termination Payment, which they had failed to do in this instance.
Specifically regarding the alleged repayment of Mr Johnson's EMI option payment, the FTT considered it "inconceivable that he would sign an agreement which did not recognise that fact [i.e. the need for repayment], given that the agreement in question precluded him from taking any separate action in respect of the option."
Accordingly the FTT allowed Mr Johnson's appeal.
Comment
Given the FTT's approach in Reid (where the tribunal held that the entire agreement clause was binding and accordingly it could not find that £30,000 of Mr Reid's termination payment was an EMI repayment), Mr Johnson's win is somewhat surprising. Although a previous decision of the FTT is not binding on the FTT when determining a later appeal (a fact acknowledged by the FTT when it stated in its judgment that Reid "is not binding on us"), it is unsatisfactory that we now have two conflicting decisions in this important area of the law.
However if the decision in Johnson is followed, taxpayers will be able to argue that HMRC must have regard to all relevant surrounding circumstances when determining the true nature of termination payments when compromise agreements are silent or unclear.
One lesson which can be taken away from both these decisions is that when drafting compromise agreements parties should take care to breakdown and label clearly and accurately the constituent parts of any termination payment if they wish to minimise the risk of a dispute arising with HMRC.
1 [2013] UKFTT 242 (TC).
2 [2012] UKFTT 182 (TC).