Introduction

The case of Revenue And Customs v Murphy ([2022] EWCA Civ 1112) adjudicated by the England and Wales Court of Appeal (Civil Division) on August 4, 2022, delves into the nuanced interpretation of the term “profit” as defined in section 62(2)(b) of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA). The appellant, Mr. Murphy, a police officer with the Metropolitan Police Service (the Met), contested the classification of certain settlement payments as "earnings" subject to income tax. This commentary dissects the Judgment, elucidating its implications for the broader legal landscape surrounding employment income taxation.

Summary of the Judgment

Mr. Murphy, along with other police officers, initiated a litigation against the Met seeking unpaid overtime and allowances under the Police Regulations 2003. To finance this legal action, the claimants engaged in a Damages-Based Agreement (DBA) with solicitors, entailing a "success fee" contingent upon successful settlement or court award. Upon reaching a settlement, the Met agreed to pay a principal sum and agreed costs. However, the Met applied Pay As You Earn (PAYE) deductions to Mr. Murphy's share of the principal sum, including portions representing the success fee and insurance premiums.

Mr. Murphy disputed the taxation of these components, leading to a series of appeals. The First-tier Tribunal upheld HMRC's assessment, considering the entire principal settlement sum as taxable earnings. The Upper Tribunal later reversed this decision, arguing that the success fee and insurance premium should be excluded from taxable profits. The Met appealed this reversal, and the Court of Appeal ultimately sided with HMRC, reinstating the First-tier Tribunal's original decision. The Court held that the success fee and insurance premium were indeed profits derived from Mr. Murphy’s employment and thus taxable.

Analysis

Precedents Cited

The Judgment extensively referenced several key cases to underpin its legal reasoning:

• Hochstrasser (Inspector of Taxes) v Mayes [1960] AC 376 - Established the "from" test to determine if payments are derived from employment.
• Eagles (Inspector of Taxes) v Levy [1934] 19 TC 23 - Addressed the treatment of settlement sums excluding costs as taxable income.
• Pook (Inspector of Taxes) v Owen [1970] AC 244, Taylor v Provan (Inspector of Taxes) [1975] AC 194, and Donnelly (Inspector of Taxes) v Williamson [1982] STC 88 - These cases explored the distinction between reimbursements for expenses and taxable emoluments.

The Court of Appeal critically assessed the Upper Tribunal’s interpretation of these precedents, particularly highlighting that the Upper Tribunal misapplied the concept of "profit" within the statutory framework of ITEPA.

Legal Reasoning

The crux of the legal reasoning centered on the interpretation of "profit" in s.62(2)(b) of ITEPA. The Court held that once the "from" test established that a payment is derived from employment, the term "profit" should be understood in its ordinary sense as a material benefit. The Upper Tribunal's approach to deducting certain expenses to determine a "net" profit was deemed inconsistent with the statutory definitions.

Specifically, the Court opined that:

• The term "profit" does not cater for deductions beyond the statutory allowances prescribed in Chapter 5 of ITEPA.
• The obligation to pay success fees and insurance premiums does not transform these payments into non-taxable elements.
• Deductions based on the means of securing the settlement (such as DBAs) are irrelevant to the classification of the payments as taxable earnings.

Thus, the entire principal settlement sum, inclusive of the success fee and insurance premiums, constituted taxable earnings under the definition provided by ITEPA.

Impact

This Judgment significantly clarifies the scope of what constitutes "profit" under employment income taxation. Key impacts include:

• Taxation of Settlement Sums: Settlement payments that include success fees and insurance premiums are to be wholly treated as taxable earnings.
• Limitations on Deductions: Apart from statutory deductions explicitly mentioned in ITEPA, no additional deductions can be made to determine net profits for tax purposes.
• Legal and Tax Advisory: Employers and employees must meticulously structure settlement agreements to ensure clarity on taxable components, avoiding unintended tax liabilities.
• Precedential Value: This case serves as a precedent for similar disputes, reinforcing the stringent interpretation of earnings under ITEPA.

Complex Concepts Simplified

The "From" Test

The "from" test determines whether a payment is derived from employment. As established in Hochstrasser v Mayes, a payment qualifies as earnings "from" employment if it is a reward for services rendered. In this case, the success fee and insurance premium were found to be directly tied to the employment, thereby satisfying the "from" test.

Interpretation of "Profit" in ITEPA

Under s.62(2)(b) of ITEPA, "profit" refers to any incidental benefit obtained by the employee. The Court clarified that "profit" should not be construed in a manner that allows for subjective deductions outside the statutory allowances. Instead, it should be viewed as the gross benefit arising from employment.

Taxable vs. Non-Taxable Reimbursements

Not all reimbursements are taxable. Payments that are strictly for reimbursing expenses incurred in the performance of duties are generally non-taxable. However, when reimbursements or additional payments are contingent upon the success of a claim related to employment, they may be classified as taxable earnings.

Conclusion

The Revenue And Customs v Murphy decision serves as a pivotal clarification in the domain of employment-related taxation. By reaffirming that success fees and associated insurance premiums derived from settlement agreements are taxable earnings, the Court of Appeal has set a clear precedent. It underscores the imperative for both employees and employers to recognize the comprehensive scope of taxable earnings under ITEPA and to approach settlement structures with informed legal and financial strategies. This Judgment not only resolves the immediate dispute but also provides a valuable framework for future cases involving the taxation of employment-related settlements.