Tax-free termination payments at risk

Liquidated
damages clauses in compromise agreements put tax-free termination payments at
risk, according to recent Inland Revenue decisions.

Such
clauses require the employee to repay any compensation received under the
compromise agreement if they claim unfair dismissal and receive damages.

But
the Revenue has said that because compensation may have to be repaid at a later
date, this renders it "employment income" rather than genuine
compensation, and is therefore chargeable for tax and National Insurance.

Emma
Bartlett, a solicitor at Speechly Bircham, warned employers not to include
liquidated damages clauses at all, to be on the safe side.

"A
liquidated damages clause should be unnecessary as a properly drafted
compromise agreement will be capable of preventing the employee from bringing
proceedings. A [liquidated damages] clause is probably unenforceable anyway
under the Unfair Contract Terms Act 1977."

Bartlett
added that an employer does not want to rely on a waiver in the compromise
agreement, it should make it clear that it should be permitted to offset
compensation against any future award it is ordered to make.

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"As
the employee is not then required to repay any sums to the employer, this
should ensure the compensation is purely ‘compensation for termination of
employment’ and so not taxable."

But
she added this had not yet been tested.