Settlement Agreements: How confidentiality and non-disclosure obligations can affect the tax treatment of termination payments

Background

The facts of the case in Mrs A v The Commissioners for HM Revenue & Customs were that an employee alleged (amongst other things) sexual harassment in the course of her employment. A chain of events began which saw her bring a grievance against her employer which proceeded to a Tribunal claim, her leaving her employment before that was heard, a settlement agreement and a substantial payment to her from the employer.

Her settlement payment was broken into three elements (she also presumably received a payment for legal costs which would have been a tax-free payment but that was not discussed in the case). Each had different tax treatment.

• First, the employee received six equal monthly payments following the date of the settlement agreement. These were stated to represent her notice period, were treated as fully taxable and subject to NICs, and were paid through PAYE.
• Secondly, she received £45,000 for injury to feelings and aggravated damages in full and final settlement of the Tribunal claim. This was paid tax-free. This tax treatment was agreed by HMRC (and the Tax Tribunal). It was accepted that it related to matters which arose before and were not connected with the termination of employment and had no element of compensating for financial loss which arose from pre-termination unlawful conduct.
  
  This reflects what some might see as an oddity in tax legislation: on the one hand payments for injury to feelings to employees before termination is in prospect are not taxed, whereas payments for injury to feelings which are made in connection with the termination of employment are taxable. The dividing line between what is and is not connected with the termination of employment can often be a difficult line to draw, but here the case was clearly successfully made.
  
  As a side comment, although no challenge appears to have been made in this case, parties should be prepared for a degree of HMRC scepticism on any allocation to pre-termination injury to feeling payments. HMRC are aware that this is a route for the tax aggressive to try to receive tax-free treatment on some of a payment made at the time of termination – particularly where, as here, the payment of £45,000 is at the upper end of what an Employment Tribunal would award, which might lead HMRC to say that the "excess" payment must be attributable to something else (and be taxable).
• However, it was the tax treatment of the third element of the payment that was in dispute with HMRC. This was by far the largest element (£1 million) and was paid "as compensation for the termination of your employment and any and all claims you may have against the employer and other related persons". As part of this, the settlement agreement went on to contain fairly standard terms with the employee agreeing (amongst other things) to withdraw the Tribunal claim, not to bring other claims, and agreeing to confidentiality and non-disclosure obligations and an agreement not to make derogatory statements about the employer or related persons.  In short, this is wording routinely seen in settlement agreements.

Payments for employee restrictions

On this third element of the payment, the Tax Tribunal made two particular points.

First, it held that (properly analysed) the whole of this element of the payment was for a restrictive undertaking not to pursue the relevant proceedings and to keep facts confidential, and not a termination payment. This case is very fact-specific and is unlikely to lead to entire payments under settlement agreements being treated as a payment for a restrictive undertaking in normal settlement situations – indeed HMRC have issued Statement of Practice 3/96 which confirms that merely repeating restrictions already contained in an employment agreement or agreeing to end/not pursue litigation will not lead to an amount being allocated to those terms unless the settlement agreement specifically allocates consideration to them. Nonetheless, employers should keep in mind whether some (possibly only a small amount) of the overall payment should be allocated to agreed restrictions to avoid the result which came about in this case from occurring.

Secondly, the employee argued that, even if this was a payment for a restriction, it was only payments for restrictions relating to working activities that are taxable as restrictive undertaking payments. The Tax Tribunal, however, held that any payment in connection with any restrictive agreement given in connection with past, current or future employment, a much broader test, was caught as a relevant taxable payment and this therefore caught the restrictions in this case. Some tax advisers had argued that payments to employees for non-disclosure were a tax-free way of making payments on termination but making tax-free payments on this basis must now be dangerous.

In tax terms, the difference between a payment for a restrictive undertaking and a termination payment is that:

• A payment for restrictive undertaking is fully taxable and fully subject to NICs (both employee's and employer's), but
• A termination payment is more favourably taxed in that it is tax and NIC free up to the first £30,000 – with the balance subject to tax and employer's NICs but free of employee's NICs.

With the potential loss of a £30,000 tax and NIC free sum, and also the loss of an employee's NIC saving on any balance, parties should therefore be careful that any payment that they intend be treated as a termination payment is not treated as a payment for restrictive undertakings.

Key takeaway for employers

This case is a reminder that:

• the restrictive undertaking regime is wide and can also arise in ways that the parties may not intend. Settlement agreements may need to be read closely to prevent this; and    
• an inadvertent wrong attribution of a payment under a settlement agreement can be extremely costly and leave employers with PAYE claims from HMRC. In this case the employer had deducted tax on the £1 million payment, possibly on a precautionary basis, and so the employer was not exposed.