Taxpayer Wins Appeal: Impact On Employee Ownership

Anyone involved in determining, or advising on, the tax treatment of compensation payments to employees would be well-advised to take account of the recent case of Reid vs HMRC [2016] UKFTT 0079 (TC).

In its judgment, the First Tier Tribunal (FTT) held that a lump sum payment made as compensation to an employee for the loss of pension, share and other contingent rights on the sale of his employing business was taxable only in part. A “golden handshake” payment to induce the taxpayer to leave his employer would have been fully taxable, but the FTT found as a question of fact that this was not the case here.

The taxpayer was employed by BP which transferred part of its business to S & J D Robertson North Air Ltd (North Air). Since North Air’s reward and benefit scheme was considered to be less generous than BP’s, a lump sum compensation payment of around £26,000 was made to the taxpayer to compensate for loss of pension, bonus and share rights and loss of lunch allowances. HMRC determined the compensation payment was fully taxable as earnings as being from the taxpayer’s employment.

The taxpayer appealed to the FTT, which rejected HMRC’s argument that the conditions contained in the agreement gave the entire payment the character of an emolument of employment. In the FTT’s view, the requirement to enter into an employment contract with North Air was not a reason for the payment, but the trigger for the payment.

The rights lost in this case were considered to be contingent rights, rather than employment rights directly connected with the employee’s employment, which would have been taxable as earnings. Accordingly, the tax treatment of the compensation payment was determined by what would have been the tax treatment of the rights which had been lost and which comprised differing components paid for differing reasons and could, therefore, be allocated between their various elements.

This case will be of interest to those involved in operating share schemes or employee share ownership generally because it confirms the application of what has become known as the “substitution principle” to payments made for loss of rights under share plans. For example, on this basis, compensation for loss of rights under a tax-advantaged Company Share Option Plan would not be chargeable to income tax, since the underlying benefits would have been free from income tax. It also highlights the need for the taxpayer to keep detailed records of the reasons for any payments made and the rationale for the tax treatment applied.