Introduction

Moorthy v. Revenue & Customs ([2016] BTC 501) is a landmark case adjudicated by the Upper Tribunal (Tax and Chancery Chamber) on January 14, 2016. The case revolves around the tax implications of a settlement payment made to an employee following the termination of his employment due to redundancy. Specifically, it examines whether certain components of the settlement are taxable under the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) sections 401 and 406.

Mr. Krishna Moorthy, the appellant, was employed as the Executive Director of Operations at Jacobs Engineering (UK) Limited. Following redundancy, he received an ex gratia settlement of £200,000, which HM Revenue and Customs (HMRC) sought to tax under ITEPA. Moorthy contested this, arguing that a portion of the settlement was compensation for injury to feelings arising from age discrimination, which should be exempt under section 406 ITEPA.

Summary of the Judgment

The Upper Tribunal upheld the original decision of the First-tier Tribunal (FTT), dismissing Moorthy’s appeal. The key findings are as follows:

• The entire settlement amount of £200,000 fell within section 401 ITEPA, making it subject to income tax.
• Section 403 ITEPA reduced the taxable threshold by considering previous redundancy payments, resulting in £180,640 being taxable.
• Damages for injury to feelings do not fall within section 406 ITEPA and thus remain taxable.
• HMRC’s concession to treat £30,000 of the settlement as exempt was rejected due to lack of statutory basis.

Analysis

Precedents Cited

The judgment extensively referenced previous cases to delineate the scope of sections 401 and 406 of ITEPA:

• Walker v Adams and others: Discussed the broad application of section 401 ITEPA to various termination payments.
• Horner v Hasted: Interpreted "disability" within tax exemptions, emphasizing medical conditions.
• Orthet Ltd v Vince-Cain: Addressed whether injury to feelings falls under section 406, which was ultimately not followed.
• Timothy James Consulting Ltd v Wilton: Further explored the definition of "injury" under section 406, reinforcing the exclusion of non-medical injuries.
• Moorthy v Revenue & Customs: Served as the current case setting a precedent excluding injury to feelings from tax exemptions under section 406.

The Upper Tribunal concluded that previous cases like Orthet and Timothy James were incorrectly decided regarding the tax treatment of injury to feelings.

Legal Reasoning

The crux of the legal reasoning centered on interpreting the term "injury" within section 406 ITEPA. The Tribunal distinguished between physical/medical injuries and psychological injuries such as injury to feelings. Drawing from the Horner case, it was established that "injury" pertains strictly to medical conditions that impact an employee's ability to perform their duties.

Consequently, non-medical awards like those for injury to feelings remained taxable under section 401, as they are connected with the termination of employment but do not qualify for tax exemptions under section 406.

Impact

This judgment clarifies that compensation awarded for injury to feelings arising from employment termination does not enjoy tax exemptions under section 406 ITEPA. It sets a clear precedent that only medically recognized injuries and disabilities qualify for such exemptions. Future cases involving settlement payments will need to differentiate between compensation for medical conditions and other forms of non-pecuniary damages to determine tax liabilities accurately.

Complex Concepts Simplified

Section 401 vs. Section 406 ITEPA

Section 401 ITEPA deals with payments received in connection with the termination of employment. These payments are generally subject to income tax unless specific exemptions apply.

Section 406 ITEPA provides exemptions for payments made due to death, injury, or disability of an employee. The critical debate in this case was whether "injury" encompasses non-medical injuries like psychological harm or injury to feelings.

Injury to Feelings

Injury to feelings refers to psychological harm or emotional distress resulting from unfair dismissal or discrimination. Unlike medical injuries, it does not necessarily involve a diagnosable condition that impairs an employee's ability to work.

Conclusion

The Upper Tribunal’s decision in Moorthy v Revenue & Customs establishes a significant precedent clarifying the limitations of tax exemptions under ITEPA. Specifically, it affirms that compensation for injury to feelings does not qualify for exemption under section 406 and remains taxable as employment income under section 401. This ruling emphasizes the necessity for precise allocation and understanding of settlement payment components to ascertain their tax obligations accurately. Consequently, employers and employees must carefully structure settlement agreements, ensuring clear differentiation between taxable and exempt components to comply with tax regulations and avoid unexpected liabilities.