The income tax treatment of termination payments is an area fraught with subtleties and uncertainties and is often open to fine interpretations. Whilst the general principles involved in determining the tax treatment of a termination payment are relatively well-understood, difficult questions are often raised in their application. Cases with similar fact patterns can sometimes result in conflicting decisions being reached, as illustrated by two recent First-tier Tribunal decisions - Johnson v HMRC  UKFTT 242 (TC) (April 2013) and Reid v HMRC  UKFTT 182 (TC) (March 2012).
In the more recent case of Johnson, the First-tier Tribunal allowed the taxpayer's appeal relating to a termination payment under a compromise agreement, whilst in Reid, a case involving another director of the same company, the First-tier Tribunal found in favour of HMRC. The cases can help to instruct employers on best practice in this area.
Mr Johnson worked as the sales director of Richardson Social Housing Limited (the 'Company') for over a year and a half until he resigned from the Company with immediate effect in December 2007. His employment contract was terminable by 6 months' notice and there was no clause providing for any payment in lieu of notice ("PILON").
Mr Johnson entered into a compromise agreement with the Company a month later in respect of the termination of his employment. That agreement contained the following key terms:
Mr Johnson was entitled to a termination payment of £75,000, less any income tax required to be deducted
The Company agreed that it would not make any deduction from the first £30,000 of the termination payment on the basis that the parties understood that such an amount could be paid tax free under "normal HMRC rules"
The only other identifiable element of the termination payment was a statement that the termination payment included Mr Johnson's "entitlement if any to a Statutory Redundancy Payment in the sum of £930", and
There was an entire agreement clause, meaning a clause stating that the written terms agreed constituted the entire contract, and that prior negotiations could not be taken into account.
In Mr Johnson's self-assessment return for 2007/8, he included £45,700 of the termination payment as taxable earnings but omitted £30,000 of the payment on the basis that this was not subject to tax by virtue of section 403 of the Income Tax (Earnings and Pensions) Act 2003.
He subsequently amended his return by omitting a further £30,000 of the termination payment on the basis that this amount represented a refund of an option he purchased under the Company's Enterprise Incentive Scheme ("EMI") and was therefore not taxable income. In support of this position, Mr Johnson pointed to evidence outside the confines of the compromise agreement which demonstrated that part of the termination payment comprised a repayment of his £30,000 EMI investment.
Mr Johnson received a refund of circa £12,000 from HMRC as a result of the amendment to his tax return. Following enquiries into Mr Johnson's tax return, HMRC demanded back the £12,000 (later revised down to £11,628) of income tax in respect of the further £30,000 omitted from his amended return.
In rejecting Mr Johnson's argument that £30,000 of the £75,700 termination payment represented a refund under the EMI, HMRC relied on the decision in Reid v HMRC. That was a case with virtually identical facts save that in Reid there was a contractual PILON provision in Mr Reid's employment contract. The First-Tier Tribunal in Reid did not consider any extraneous evidence in construing the compromise agreement due to the entire agreement clause and held that it was unable to find an implied term in the compromise agreement or infer from the agreement that the £30,000 of Mr Reid's termination payment was a refund of an amount paid for an EMI option, despite there being clear extraneous evidence demonstrating such payment was indeed a refund.
Notwithstanding the First-tier Tribunal's decision in Reid (which as a First-tier Tribunal decision does not set a precedent), a case with virtually identical facts, the Tribunal held that HMRC could not rely on the entire agreement clause as it was not a party to the compromise agreement. The Tribunal held that in determining the nature of the termination payment and the correct tax treatment, HMRC should identify the individual components of the termination payment (as required by the HMRC Employment Income Manual) and in doing so should look outside the specific terms of the agreement. It was clear that Mr Johnson would not have entered into the compromise agreement if part of the termination payment was not a refund of his EMI investment.
The taxpayer's win in Johnson is perhaps unexpected given the approach of the First-tier Tribunal in the earlier decision in Reid (where the tribunal held that the entire agreement clause was binding). Strictly speaking, an earlier decision of the First-tier Tribunal is not binding on the tribunal itself in determining a later appeal (a fact acknowledged by the First-tier Tribunal in Johnson). However, consistency in the decision-making of the First-tier Tribunal is in the interests of the administration of the taxation system for all concerned (HMRC, taxpayers and tax professionals) and it is therefore unsatisfactory that we now have two conflicting decisions on substantially the same facts.
If the decision in Johnson is followed, taxpayers will be able to argue that HMRC must have regard to all relevant surrounding circumstances when determining the true nature of termination payments when compromise agreements are silent or unclear. "Entire agreement" clauses will not preclude the taxpayer from introducing extraneous evidence to clarify the true nature of the termination payment or components of the termination payment if the termination payment is made in respect of more than one matter. However if the decision in Reid is followed, taxpayers will effectively be bound by the terms of the compromise agreement itself if they include an 'entire agreement' clause. In some respects the Reid approach may be too narrow - after all, it is certainly the case that in other respects evidence beyond the terms of an employment contract clearly is considered. For example, in determining whether a termination payment is tantamount to a contractual PILON, HMRC and the courts will often consider whether there is a custom or practice of an employer to make PILON payments even if there is no contractual obligation to do so.
What should employers do?
When presented with two conflicting decisions such as Johnson and Reid, the best strategy must be to avoid the area of uncertainty that gave rise to the conflicting decisions in the first place. In particular, parties should break down and clearly and accurately describe in the compromise agreement itself the component parts of any termination payment. The parties should also make an effort to apportion justifiable and reasonable amounts to each constituent part of a termination payment so that there can be no suggestion of the taxable components of a termination payment being understated.
These measures, if done properly, should minimise the risk of a dispute arising with HMRC because it will not be necessary to introduce extraneous evidence to demonstrate the reasons for a termination payment, only to then have the dispute with HMRC over whether that extraneous evidence is relevant.