Payment of legal costs under a settlement agreement – tax considerations

Employment lawyers often advise their clients on entering into settlement agreements as a cost-effective and commercial solution to resolving disputes rather than resorting to litigation in the Employment Tribunal. An important issue that arises in practice are the tax implications of termination payments, particularly where one party agrees to pay the other’s legal costs under a settlement agreement. Typically, the invoice is in the name of the client (former employee) but marked payable by the former employing company.

 Background

As a general rule, termination payments are chargeable under Part 6 of the Income Tax (Earnings and Pensions) Act 2003 (“ITEPA 2003”).

S 401 ITEPA 2003 illustrates the broad scope of Part 6. S 401(1) states that Part 6 “applies to payments and other benefits which are received directly or indirectly in consideration or in consequence of, or otherwise in connection with –

(a)   the termination of a person’s employment,

(b)   a change in the duties of a person’s employment, or

(c)    a change in the earnings from a person’s employment,

by the person, or the person’s spouse [or civil partner], blood relative, dependant or personal representatives.”

In Moorthy v Commissioners for HMRC [2015] IRLR 4, the First-Tier Tax Tribunal commented at paragraph 64 that s 401 ITEPA 2003 is a “very widely drawn provision. Not only does it catch payments made directly in consideration of a termination, or directly in consequence of a termination, but indirect payments of either type, but is then further expanded to include payments which are not even in consideration or in consequence of a termination but ‘otherwise in connection with’ a termination.”

Exception for legal costs – s 413A ITEPA 2003

On the face of it, s 401 ITEPA 2003 can be construed wide enough to encompass a payment in respect of legal costs. This, however, was considered widely unpopular, given that in practice, employers will normally contribute towards the legal costs incurred by the employee in taking advice on a settlement agreement.

The HMRC’s initial response to this was to relax the strict letter of s 401 by issuing Extra Statutory Concession A81, confirming that the Revenue would not make legal costs payable under a settlement agreement taxable under s 401 ITEPA 2003. This Extra-Statutory Concession was eventually put into statutory form when ITEPA 2003 was amended by introducing s 413A, which came into effect on 6 April 2011 (see regulation 10 of the Enactment of Extra-Statutory Concessions Order 2011 (SI 2011/1037))

S 413A ITEPA 2003 states that there are exceptions for payments of certain legal costs provided that Conditions A and B in subsections (2) and (3) are met:

·       Condition A: the payment meets the whole or part of the legal costs incurred by the employee exclusively in connection with the termination of the employee’s employment.

·       Condition B: s 413A(3) sets out various means of satisfying this. Relevant to settlements is s 413A(3)(b), which states that Condition B is met if “the termination of the employee’s employment results in a [settlement] agreement between the employer and employee” and the settlement agreement “provides for the payment to be made by the employer” and “the payment is made directly to the employee’s lawyer”.

The HMRC Manual contains guidance on s 413A at EIM13740. Unhelpfully, the guidance is rather slim. However, the guidance does provide the following clarifications:

·       S 413A does not apply to other professional costs (eg accountancy fees) but it can cover expenses of expert professional witnesses incurred by the employee’s legal advisors.

·       S 413A does not allow an employee to claim a deduction for his own legal costs in any way. The payment must be made directly to the employee’s solicitors.

Furthermore, the HMRC Manual reminds taxpayers that the payment must be made pursuant to a specific term in the agreement that settles the dispute.

What to take away

It’s very common in practice for an employer to agree to pay the legal costs incurred by the employee under a settlement agreement. Such provision is particularly popular given that the Employment Tribunal is a no-costs regime and so successful claimants are in practice unlikely to recover their costs at the Tribunal. These costs considerations often makes settling a claim more attractive than litigating in the Tribunal.

When negotiating a settlement agreement, employment lawyers should ensure that any provision that purports to cover an employee’s legal fees complies with s 413A ITEPA 2003. If the specific term under the settlement agreement fails to satisfy both conditions A and B of s 413A, the legal costs will become chargeable under s 401 ITEPA 2003. In complex cases, specially where the employee has incurred legal fees prior to termination, advice from a specialist tax adviser is advisable to ensure that the conditions under s 413A are met.

Note: Farore Law are employment lawyers specialising in discrimination, whistle-blowing and misconduct law, not tax law. This blog post is merely meant to provide a high-level background of s 413A ITEPA 2003 and should not be construed as tax advice. Any queries regarding the application of s 413A should be directed to a specialist tax adviser.