Compensation fully taxable despite inclusion of contribution to legal costs

The Court of Appeal has ruled that a settlement sum paid to a police officer following litigation over loss of earnings was taxable in full, even though some of it represented a contribution to his legal costs. The separate payment for agreed costs payable to his lawyers was not taxable. However, this did not cover the success fee or the premium for insurance arranged to cover liability for costs if the claim did not succeed, for which the taxpayer remained liable.

The Court of Appeal dismissed the taxpayer’s argument that he should not be taxed on money that he had to pay over to his solicitors and his insurers. It pointed out that this was based on a misunderstanding of the tax legislation. In any case the employers had increased the settlement sum to reflect that fact that the entire payment would be taxable as earnings.

This case is a reminder that if a payment is taxable as earnings, the total tax payable cannot not be reduced to reflect liabilities the employee has to meet out of these payments. While certain expenses in relation to employment are deductible from earnings under express provisions in the tax legislation, such allowable deductions do not extend to legal fees, even if they are incurred in a dispute with the employer.

That means where a claim for loss of earnings is settled, both parties need be aware that the tax treatment of payments for legal fees will depend on the way the settlement is structured. A global settlement inclusive of legal fees which the employee remains liable to meet is likely to be taxable in full. However, if the employer’s solicitors agree to accept a separate sum in settlement of their costs, this will not normally be taxable as earnings.

Different rules apply where the employment is terminated under a settlement agreement. In that case there is a specific exemption which means that agreed payments towards an employee’s legal costs are not taxable, provide certain conditions are met. However in other circumstances, if an employer makes a contribution to legal fees for which the employee remains liable, this would be taxed as earnings, even if they are attributable to a dispute with the employer.