Settlement agreements (Formerly compromise agreements)

Transcription

1 FORUM LAW FACT SHEET Settlement agreements (Frmerly cmprmise agreements) Where an emplyee has ptential claims against the emplyer under the Emplyment Rights Act 1996 r ther emplyment legislatin, r where the emplyee wuld therwise have a claim fr breach f cntract, a settlement agreement (frmerly knwn as a cmprmise agreement) can be entered int by the emplyee and emplyer t end the emplyment n the terms set ut in that agreement. (There are a few instances under emplyment law when claims cannt be ended with a settlement agreement). Key managers/sharehlders may sign settlement agreements if they leave emplyment when the emplying cmpany is sld. By entering int a settlement agreement the emplyer has certainty that the emplyee will have n claim in the future against the emplyer. Amng ther things, the settlement agreement will deal with all payments and benefits wing r agreed t be paid t the emplyee. Whilst the settlement agreement is signed n terminatin, nt all payments and benefits within it will necessarily fall within ITEPA 2003, Part 6, Chapter 3, which is a specific set f prvisins dealing with payments and benefits n terminatin. All the cnsideratins set ut in: Hw culd a terminatin payment be taxed Terminatin payments taxed as earnings, and Terminatin payments qualifying fr the 30,000 exemptin are relevant here. In practice, mst settlement agreements will include sme element f cmpensatin and it is this element which ften requires the mst analysis (see: Cmpensatin payments--risk f challenge n tax status). Identifying the cmpnent parts f the Settlement Agreement Frum Law Fact Sheet Settlement Agreements Page 1

2 As with all terminatin payments, the tax treatment will fllw the cmpnent parts. A settlement agreement will either set ut all payments and benefits individually r have ne glbal cmpensatry sum. In bth cases, the emplyer shuld keep recrds f the discussins abut, and the basis f, each payment t enable the emplyer t justify and defend any challenge. If a glbal sum is used in the first place the emplyer will need t analyse it t wrk ut hw t tax it. If HMRC enquires int the tax treatment f a payment, the emplyer will need evidence t shw what the glbal sum was made up f. Gd practice is t set ut payments and benefits individually. HMRC ften challenge the tax treatment f terminatin payments in settlement agreements. HMRC will cnsider the payments t see whether the crrect label has been given t the payment. Officers are specifically directed t d this bth generally and particularly in respect f payments labelled as cmpensatin. EIM12805, EIM13005 Tw recent First-tier Tax Tribunal cases have highlighted sme key pints in this area: Reid and Jhnsn. Bth Reid and Jhnsn were emplyed by the same cmpany and their emplyment was terminated at the same time. Bth had paid 30,000 t the cmpany fr the grant f ptins under an EMI scheme. Bth were f the view that part f their terminatin payment included repayment f this 30,000 sum (which wuld have been a repayment f capital and hence nt a taxable receipt). In bth cases the cmprmise agreements (nw knwn as settlement agreements) did nt split ut the cnstituent parts f the terminatin payments but instead prvided fr an verall figure subject t tax as required by law. In bth cases HMRC treated the terminatin payments as nt including the nn-taxable 30,000 repayment relating t the ptin. Instead, HMRC treated the whle f the terminatin payments as cmpensatry payments fr lss f ffice and hence subject t incme tax abve the exemptin fr the first 30,000 (including statutry redundancy entitlement). Reid v HMRC [2012] UKFTT 182 (TC) Jhnsn v HMRC [2013] UKFTT 242 (TC) In the Reid case, the Tribunal fund that the existence f an entire agreement clause, and the applicatin f case law principles f cntractual cnstructin, meant that it culd nt lk utside f the cmprmise agreement t determine whether the ttal terminatin payment included 30,000 by way f ptin repayment. Accrdingly, it fund that the cmprmise agreement did nt include such a sum. Frum Law Fact Sheet Settlement Agreements Page 2

3 Reid v HMRC [2012] UKFTT 182 (TC) Investrs Cmpensatin Scheme v West Brmwich Building Sciety [1998] 1 All ER 98 Hwever, in the later case f Jhnsn, the Tribunal (which was nt bund by Reid) decided differently. The Tribunal fund that HMRC was bliged, as set ut in its wn manual, t identify the cmpnent parts f the payment; an entire agreement clause in a cmprmise agreement did nt preclude HMRC r the Tribunal frm cnsidering the surrunding backgrund and circumstances t the payment, and the rules f cntractual cnstructin cnsidered in Reid nly applied t a dispute between the parties t the cntract and nt t HMRC (which was nt a party). In Jhnsn the Tribunal fund, n the facts, that Mr Jhnsn was clearly expecting t receive 30,000 by way f repayment f his ptin subscriptin and that he wuld nt have signed the cmprmise agreement had it nt cntained such amunt. Accrdingly, the Tribunal determined that the terminatin payment included 30,000 by way f a nn-taxable repayment f Mr Jhnsn's ptin subscriptin mney. Jhnsn v HMRC [2013] UKFTT 242 (TC) These interesting, yet cnflicting, cases are bth First-tier Tax Tribunal decisins and s d nt set binding precedent. The Reid decisin was nt fllwed in Jhnsn and practitiners see Jhnsn as the mre reasnable decisin. What bth cases highlight is the imprtance f expressly specifying in settlement agreements exactly what each cmpnent f a terminatin payment is made fr. Cmpensatin payments--risk f challenge n tax status These are mst vulnerable t attack as they will fall int ITEPA 2003, Part 6, Chapter 3 and benefit frm the 30,000 exemptin at ITEPA 2003, ss and als are payable cmpletely free f natinal insurance cntributins (NIC). Enquires may be pened int payments which have already been taxed t incme tax purely t recver the NIC. Fr mre details f these types f payments, see: Terminatin payments qualifying fr 30,000 exemptin. ITEPA 2003, ss A The cmpensatin payment may be made fr ne r a cmbinatin f reasns. Fr example, it culd be damages fr breach f cntract (ie failure t give Frum Law Fact Sheet Settlement Agreements Page 3

4 prper ntice), r damages paid t settle claims that were brught under the Emplyment Rights Act 1996 (ERA 1996). Since ITEPA 2003, Part 6, Chapter 3 nly applies if the sum in questin is nt therwise taxable, HMRC will lk t the cntract terms which gverned the emplyment t frm a view as t whether the cmpensatin is truly that, r whether it is taxable (nrmally under ITEPA 2003, s 62, s 225 r s 394) because it relates t a cntractual right r has its surce in the terms f the emplyment. Examples f this are given by HMRC in its Emplyment Incme Manual (at EIM13924). ITEPA 2003, s 401(3) EIM13924 Where the cmpensatin is in respect f an ERA 1996 claim, HMRC will lk thrugh the payment t determine its surce and tax it accrdingly. See suggested further reading in Simn's Taxes. HMRC will als lk clsely at the quantum f any cmpensatin payment r benefit and if it exceeds what HMRC believes wuld be payable as damages then it will cnsider whether any part is, in substance, paid fr sme ther reasn such as: EIM12852 a terminal bnus fr services a payment n retirement a cntractual payment a restrictive cvenant, r a custmary payment Fr mre detailed analysis see: Hw culd a terminatin payment be taxed? and Terminatin payments taxed as earnings. HMRC expects emplyers t apply smething called the 'Gurley principle' when determining quantum f damages; this is the principle that a persn must nt be placed in a better r wrse psitin than if the cntract had actually been carried ut (see EIM13070 fr further discussin n this). In additin, HMRC expects emplyers t cnsider hw the damages shuld be mitigated in the particular circumstances. Mitigatin is the reductin f the damages t take accunt f surrunding factrs. See the example belw in respect the likelihd f new emplyment. Frum Law Fact Sheet Settlement Agreements Page 4

5 British Transprt Cmmissin v Gurley [1955] 3 All ER 796 EIM13070 In practice, this ften des nt happen. If, fr example, an emplyee is terminated withut prper ntice, and there is n pay in lieu f ntice clause in his emplyment cntract, the emplyee will have a claim fr breach f cntract fr failure t give ntice. The emplyee will ften expect t be paid the grss amunt f salary and benefits during this perid, regardless f whether such amunt falls within the 30,000 exemptin. If an emplyer tries t reduce this amunt under the Gurley principle, r t mitigate t take accunt f the likelihd f the emplyee finding new emplyment quickly, the emplyee may nt sign the settlement agreement. In such circumstances, the emplyer may agree t pay the grss amunt as damages as the nly way t reach an agreed settlement. In such circumstances, the emplyer will need apprpriate recrds t help defend the quantum f the payment and t shw that is nt payment fr anything else. Significant cmpensatry sums which are truly ex-gratia are the hardest t defend. In these cases it helps t wrk backwards and shw hw the facts indicate that all the payment cannt have been fr any reasn that wuld give rise t a tax charge. Restrictive cvenants Restrictive cvenants are undertakings given by emplyees during emplyment r n terminatin which restrict their cnduct r activities. Where the terminatin has resulted in a breach f the emplyment cntract, any restrictive cvenants cntained in that cntract will n lnger be enfrceable. The settlement agreement may reprduce restrictive cvenants which were in the emplyment cntract. HMRC cnfirms in SP 3/96 that as lng as these are n mre than the nes that were in the emplyment cntract in the first place and n payment is made by the emplyer t the emplyee specifically t enter int them, then HMRC will nt seek t attribute any value t the giving f such cvenants. If a value was attributed it wuld be taxable under ITEPA 2003, s 225. Additinally, by agreeing in the settlement agreement nt t pursue claims, the emplyee is giving an undertaking that restricts cnduct. HMRC des nt seek t attribute value t that undertaking unless the agreement includes a specific sum in respect f that undertaking. Frum Law Fact Sheet Settlement Agreements Page 5

6 Settlement agreements may cntain a repayment clause which prvides that if, despite the agreement, the emplyee des later initiate prceedings befre a tribunal r curt then any sum paid under the settlement agreement must be repaid t the emplyer. In nrmal cases, HMRC des nt argue that such a clause means that a sum is being attributed t the undertaking nt t pursue claims. HMRC explains that in virtually all cases, the sum paid under the agreement can be fully attributed t settlement f the claims. Legal fees There is n charge t tax n certain legal csts paid by the emplyer n behalf f the emplyee. T be paid tax free, the fllwing must be fulfilled: ITEPA 2003, s 413A the payment must meet the whle r part f the legal csts f the emplyee in cnnectin with the terminatin, and the terminatin f the emplyment results in a settlement agreement between the emplyer and emplyee, which prvides fr payment t be made by the emplyer directly t the emplyee's lawyer, r the payment is made pursuant t a curt r tribunal rder Prir t 1 March 2013, references in ITEPA 2003, s 413A(3) t 'settlement agreement' were t 'cmprmise agreement'. The change has been made due t cncerns that the reference t 'cmprmise agreement' meant the legislatin was narrwer than the frmer psitin under ESC A81 (upn which ITEPA 2003, s 413A is based). The amendment seeks t revert t the psitin under ESC A81 and ensures that legal fees paid under settlements agreed under ACAS dispute reslutin prcedures and equality legislatin enacted in 2010 are als included within the scpe f the incme tax exemptin. SI 2013/234, art 3 ITEPA 2003, s 413A(3) It remains imprtant t ensure the settlement agreement fulfils all the necessary emplyment law requirements (such as including a statement that the emplyee has sught legal advice and naming the legal adviser) and that the settlement agreement sets ut what is t be paid and that it is paid directly t the lawyer. Frum Law Fact Sheet Settlement Agreements Page 6

7 Payments after terminatin Payments under settlement agreements which are paid after the P45 is issued are taxed using an 0T cde (which means n persnal allwances are given). Essentially, this taxes the payment as if it was paid in the first week r mnth f the tax year but withut any persnal allwances. As a result, large taxable payments will be taxed at a cmbinatin f basic, higher and additinal tax rates and mre tax will be cllected at surce. The individual must reprt the terminatin payment in their self-assessment return and will pay mre tax r can claim a repayment if the tax calculated thrugh the peratin f the 0T cde is mre r less than the actual tax liability. SI 2003/2682, reg 37 In certain circumstances, (nrmally where small payments are cncerned) the emplyee will be better ff if he receives the payment befre the P45 s that he can benefit frm the persnal allwances. All such payments are nw prcessed thrugh the real time infrmatin system and the date f leaving is reprted via the emplyer's full payment submissin. At present emplyers are still required t issue P45s t departing emplyees. Tax indemnities Mst settlement agreements have an indemnity frm the emplyee t the emplyer fr PAYE and primary (emplyee) class 1 NICs which the emplyer is later assessed t pay. (In mst cases an emplyer cannt recver secndary (emplyer's) class 1 NIC frm an emplyee, (SSCBA 1992, Sch 1, para 3A)). Indemnity prtectin is gd t have but, in practice, is cstly t enfrce. If there is any dubt as t the tax psitin f a settlement agreement, it is pen t the emplyer t withhld the tax and seek clearance under the nnstatutry business clearance prcedure. Frum Law Fact Sheet Settlement Agreements Page 7