Tax free terminations jeopardised

United Kingdom
A recent High Court case has changed the established tax treatment of some lump sum payments on termination. In Richardson (HM Inspector of Taxes) v Delaney, decided 11 June 2001, a payment of £75,000 was held to be fully taxable (with no £30,000 exemption) because the payment was made as part of a negotiated deal for the termination of the employee's employment "by mutual consent".

This is an important judgment affecting consensual terminations. The Inland Revenue are likely to argue that where a settlement is agreed prior to termination the whole amount is taxable. Great care will now be required to ensure that the £30,000 exemption can apply. We consider that employers can only be certain that the £30,000 exemption will apply if negotiations are not concluded until the employment has terminated and there is a genuine breach of contract. Any resulting payment would then be compensation for breach of contract.

The facts of the case are as follows. Mr Delaney's contract of employment included a notice entitlement of 18 months and a pay in lieu of notice ("PILON") clause. The exact wording of the PILON clause was "The Company may at its absolute discretion elect to terminate the employment of the Executive with immediate effect by paying to the Executive salary in lieu of notice".

On 1st December 1995 the Company gave Mr Delaney two letters. The first gave notice to terminate the employment although no specific end date was set. The letter also put Mr Delaney on garden leave. This letter therefore made it clear that there was no immediate termination and employment was continuing. The second letter was "Without Prejudice". It set out various proposals such as termination by mutual agreement on 28th December and lump sum compensation of £68,000. Negotiations took place and Mr Delaney finally accepted a lump sum of £75,000 plus the transfer of his car. The employment terminated on 28th December.

Mr Delaney claimed that the lump sum was in compensation for breach of contract and should be charged to tax under section 148. This would mean that the first £30,000 would be tax free. Mr Delaney claimed that he had no right to enforce the PILON (it was simply an option for the Company); he could only sue for breach of contract or negotiate and settle a sum with the Company to compensate for that breach. The Court commented that Mr Delaney effectively accepted an agreed negotiated sum as an alternative to his having claimed damages.

The High Court accepted that the PILON clause had not been invoked but rejected the argument that Mr Delaney had been wrongfully dismissed. Instead the Judge said "it is true to say that the termination of the employment was, to some extent at any rate, on the basis of an ad hoc agreement between the parties". He then stated: "How can it be said that by giving notice under the contract, retaining the taxpayer in employment for four weeks, paying him for that period, which is unquestionably subject to tax, and then agreeing with him a package for the immediate termination of employment after the four weeks, which in economic terms as between him and the employer is at any rate very close to what would have been due to have been paid him under the PILON, and thereby terminating, how can that variation between two terms, both of which would have been subject to tax, how can this intermediate course manage to escape being subject to tax? In my judgment the answer is that it does not".

If you would like to discuss the impact of this case on your own practices or if you require any advice or assistance on termination issues please contact Simon Jeffreys by e-mail at simon.jeffreys@cms-cmck.com or by telephone on +44 (0)20 7367 3421 or Anthony Fincham by e-mail at anthony.fincham@cms-cmck.com or by telephone on +44 (0)20 7367 2783.