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In our newsletter of 6 May 2005, we explained the Court of Appeal decision in the case Hinton v University of East London, a case involving the wording of a compromise agreement. Because the agreement did not specifically refer to the "particular proceedings" that were being compromised, as required by section 203(3)(b) of the Employment Rights Act 1996 (ERA 1996), the Court of Appeal decided that it was not effective and did not prevent Dr. Hinton from making a complaint to an employment tribunal, the situation that the compromise agreement was intended to prevent.
The Court of Appeal confirmed that a single compromise agreement could encompass claims brought under more than one jurisdiction but indicated that compromise agreements should be tailored to the individual circumstances of each situation.
Under the provisions of section 225 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003), any payment made to an employee in consideration of an undertaking that restricts an employee's conduct or activities, i.e. a restrictive covenant, is liable in full to income tax under PAYE. However, under the special provisions of HMRC's Statement of Practice 3/96, payments made to employees in conjunction with compromise agreements are not taxable, or are taxable only to the extent that, together with other exempt payments, they exceed £;30,000.
The Court of Appeal's decision raises the question as to whether, where the undertaking given by the employee in a compromise agreement is not valid in law, HMRC would hold that Statement of Practice 3/96 still applies, or whether HMRC would take the view that, because the agreement is not valid, any payment by the employer in respect of the agreement would be taxable in full as a restrictive covenant or as earnings from the employment.
HMRC has given the following reassuring response to our enquiry on this matter. We have made minor adjustments to the wording for the purposes of clarity.
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"SP3/1996 is not limited to such a compromise agreement. Whilst inevitably that is the most common scenario in which the Statement is applied, the Statement is applicable to any type of termination agreement. What it seeks to achieve is identification of the substance of a transaction, namely the underlying reason for which the payment under the agreement is made, and thereby acceptance that the undertaking not to litigate, which accompanies the process, has no monetary value to which s225 ITEPA 2003 could apply. HMRC will, in such cases, consider all the background of the case, in particular the claims made by the parties, to determine what the substance of the payment under the agreement is - namely, what it is really paid for.
Where the agreement fails to meet the specific requirements in s203 ERA 1996, that does not apparently alter the substance of the matter. It does mean that the parties have failed to finally compromise extant claims in the manner they thought they had, but that does not alter the claims made by the parties at the time, nor does it mean that some value can retrospectively be attributed to the undertaking not to litigate.
HMRC will continue its present approach to all termination agreements (including compromise agreements). Namely, we will identify the reason in substance for the payment being made under the agreement by considering the agreement itself in the light of the surrounding facts and documents. An undertaking not to litigate associated with an agreement which is understood at the time to do no more than finalise the position will not be attributed value, whether or not the agreement is void."
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HMRC's approach, therefore, looks more at the intentions of the parties at the time that the agreement was made than at whether it ultimately proves to be unenforceable in law. That is reassuring for both employers and employees as it means that, even if the agreement later proves to be ineffective, the parties are not going to find themselves liable for unexpected tax and NICs charges.
...back to 24 November 2005
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For Payroll and Human Resource Professionals
