Costs deducted from settlement agreement payment were taxable as earnings.
In HMRC v K Murphy[2022] EWCA Civ 1112 (4 August 2022), the Court of Appeal (CA) held that an amount paid by an employer to settle an employment law claim was taxable and the fact that some of that money was used to pay the claimants’ legal costs, or that it was paid by the employer on the claimants’ behalf to a third party, did not change the character of the payment as earnings.
The taxpayer, together with other police officers, had brought a claim against their employer, the Metropolitan Police, for unpaid overtime. To fund their own legal costs for those proceedings, the claimants entered into an agreement with their lawyers which provided for a ‘success fee’ based on a percentage of any settlement amount. They also took out insurance against the risk of having to pay the Met’s legal costs.
In the event, the Met settled the substantive claims out of court, agreeing to pay the claimants some £4.2m plus ‘agreed costs’.
Under the settlement, the success fee and insurance premium were not part of the ‘agreed costs’. They would instead be deducted from the £4.2m and paid directly by the Met. The remaining balance would be paid to the claimants and would be subject to PAYE and NICs.
The Met applied PAYE to the whole of the settlement sum including the part representing the success fee and insurance premium. The question was whether those two elements were derived from employment and should therefore be treated as earnings. The Upper Tribunal had decided in the taxpayers’ favour.
Allowing HMRC’s appeal, the CA held that the whole sum represented remuneration for the taxpayers’ services and was taxable. Crucially, the payment did not cease to be taxable as a result of the recipients using some of the money to pay their own expenses.
Why it matters: Sometimes it is the simplest words which can create the knottiest tax problems. Here the words were ‘from’ and ‘profit’. The context is a claim by members of the Met Police for arrears of pay and allowances. A settlement was reached with the employer under which a lump sum payment was made (without admission of liability) which was then allocated to individuals. The individuals had taken out a damages-based agreement and insurance to fund the litigation. The settlement did not cover those costs but as part of the mechanism for settling the case it was agreed that the actual payment of those costs would be made by the employer out of the overall settlement amount with the net amount being paid to the individuals.
The element of the settlement relating to overtime and allowances was taxable. The question was whether the taxable amount was reduced by the payment of the costs. The Met applied PAYE to the whole amount and individual officers appealed. The FTT decided that the whole amount was taxable, but the UT held that the cost amount was not earnings as it was not a profit derived from the employment. The Court of Appeal has reversed that decision and reinstated the decision at first instance that the whole amount was taxable.
It held that the full amount received was ‘from’ the employment and that the word profit in the phrase ‘gratuity or other profit or incidental benefit’ did not mean net or economic profit. It simply meant a benefit derived from the employment.
Employment tax specialists will find much of interest here. The court has done a valuable job in stripping the key tests back to their essentials and navigating through the complexities, and occasional inconsistencies, of the extensive case law in this important area.
Costs deducted from settlement agreement payment were taxable as earnings.
In HMRC v K Murphy[2022] EWCA Civ 1112 (4 August 2022), the Court of Appeal (CA) held that an amount paid by an employer to settle an employment law claim was taxable and the fact that some of that money was used to pay the claimants’ legal costs, or that it was paid by the employer on the claimants’ behalf to a third party, did not change the character of the payment as earnings.
The taxpayer, together with other police officers, had brought a claim against their employer, the Metropolitan Police, for unpaid overtime. To fund their own legal costs for those proceedings, the claimants entered into an agreement with their lawyers which provided for a ‘success fee’ based on a percentage of any settlement amount. They also took out insurance against the risk of having to pay the Met’s legal costs.
In the event, the Met settled the substantive claims out of court, agreeing to pay the claimants some £4.2m plus ‘agreed costs’.
Under the settlement, the success fee and insurance premium were not part of the ‘agreed costs’. They would instead be deducted from the £4.2m and paid directly by the Met. The remaining balance would be paid to the claimants and would be subject to PAYE and NICs.
The Met applied PAYE to the whole of the settlement sum including the part representing the success fee and insurance premium. The question was whether those two elements were derived from employment and should therefore be treated as earnings. The Upper Tribunal had decided in the taxpayers’ favour.
Allowing HMRC’s appeal, the CA held that the whole sum represented remuneration for the taxpayers’ services and was taxable. Crucially, the payment did not cease to be taxable as a result of the recipients using some of the money to pay their own expenses.
Why it matters: Sometimes it is the simplest words which can create the knottiest tax problems. Here the words were ‘from’ and ‘profit’. The context is a claim by members of the Met Police for arrears of pay and allowances. A settlement was reached with the employer under which a lump sum payment was made (without admission of liability) which was then allocated to individuals. The individuals had taken out a damages-based agreement and insurance to fund the litigation. The settlement did not cover those costs but as part of the mechanism for settling the case it was agreed that the actual payment of those costs would be made by the employer out of the overall settlement amount with the net amount being paid to the individuals.
The element of the settlement relating to overtime and allowances was taxable. The question was whether the taxable amount was reduced by the payment of the costs. The Met applied PAYE to the whole amount and individual officers appealed. The FTT decided that the whole amount was taxable, but the UT held that the cost amount was not earnings as it was not a profit derived from the employment. The Court of Appeal has reversed that decision and reinstated the decision at first instance that the whole amount was taxable.
It held that the full amount received was ‘from’ the employment and that the word profit in the phrase ‘gratuity or other profit or incidental benefit’ did not mean net or economic profit. It simply meant a benefit derived from the employment.
Employment tax specialists will find much of interest here. The court has done a valuable job in stripping the key tests back to their essentials and navigating through the complexities, and occasional inconsistencies, of the extensive case law in this important area.
