Termination payments: clarity on the disability tax exemption

In a recent case, the First Tier Tax Tribunal has explored the correct test for section 406 of the Income Tax (Earnings and Pensions) Act 2003, which allows termination payments made on account of an employee’s disability or injury to be paid completely free of tax and NICs.

The Tribunal has confirmed that section 406 ITEPA can apply to a portion of a termination payment made on account of an employee’s disability, even where the entire termination payment is not made on account of disability.

The employee had been on long term sick leave and receiving benefits under the employer’s PHI scheme. The employer terminated their employment via a settlement agreement and paid the employee a lump sum expressed to be “compensation for loss of office and termination.” This included an amount intended to settle a claim under the employer’s PHI scheme.

HMRC argued that the tax exemption under section 406 ITEPA could not apply to the payment, as it was not made solely on account of the employee’s disability (but for other reasons as well).

The Tribunal rejected HMRC’s “all or nothing” interpretation of section 406 ITEPA and considered that guidance set out in HMRC’s manual had incorrectly encapsulated the test for section 406 ITEPA.  

In its decision, the Tribunal emphasised that the purpose of the disability exemption is to exempt any payment made on account of injury or disability, regardless of whether other payments are being made to the employee as part of the same deal.  Where it could be established that some part of the payment falls within section 406 ITEPA, that part of the payment should be exempt.  

In this case, the Tribunal held that the part of the termination payment intended to settle the claim under the PHI scheme was clearly on account of the employee’s disability and so should have attracted the exemption. It was also pointed out to HMRC that its approach in this case was at odds with guidance elsewhere in its manual that accepted the possibility of an apportionment where a payment relates to more than one issue. HMRC reconsidered its position and offered an apology.

This judgment provides welcome clarity for employers and tax practitioners. However, where a termination payment is being paid for multiple reasons, our recommendation remains the same - to clearly split out any portion made on account of an employee’s disability or injury to help prevent such disputes arising.