The recent Tax Tribunal judgment in Mathur v HMRC serves as a stark reminder for employers of the importance of getting things right when it comes to the tax treatment of termination payments in settlement agreements, in particular in circumstances where those payments are intended (in full or in part) as compensation for injury to feelings in the context of alleged discrimination.

It is also a helpful reminder of the principle that, when it comes to settling discrimination claims:

  1. in certain circumstances, payment for injury to feelings which is not related to the termination of employment can be made tax free; whereas
  2. any payment for injury to feelings which is related to the termination of employment is taxed in the usual way (subject to the usual £30,000 tax free allowance).

What happened in Mathur v HMRC?

In Mathur v HMRC, the employer had settled multiple employment related claims brought by Ms Mathur, including for sex discrimination, for a sum of around £6 million under a settlement agreement. The employer had deducted around £2.6 million in tax from this payment under PAYE.

Wanting to avoid a hefty tax liability, Ms Mathur argued in the Tax Tribunal that the payment, or at least part of it, was not made in relation the termination of her employment, but rather was injury to feelings compensation in relation to historic acts of sex discrimination which were unrelated to the termination.

Unfortunately for Ms Mathur, the Tribunal disagreed, and the entire settlement payment (less the £30,000 tax free allowance, and some apportionment towards legal fees) was held to be taxable.

The wording of the settlement agreement played a role in influencing the Tribunal’s decision here in a number of ways:

  1. firstly, it did not expressly distinguish the sums being paid in respect of historic discrimination, and therefore injury to feelings unrelated to the termination, from those being paid as compensation for termination of employment;
  2. instead, it lumped all of these payments together as one compensation payment; and
  3. it also went on to state that £30,000 of the whole payment would be paid tax free, as well as apportioning some as a contribution to legal costs.

The Tribunal’s view was therefore that this indicated that the whole payment was in fact a termination payment (rather than partially compensation for injury to feelings in respect of historic acts of discrimination). 

It is worth noting that, as the employer had taken a conservative approach to tax deductions, and had simply taxed the entire settlement figure (less the £30,000 tax free allowance, and sums apportioned to legal fees) via PAYE, it did not incur any additional tax liability in this instance.  However, had it taken a more relaxed approach, it could very easily have incurred a significant liability here.

What could have been done differently?

Ms Mathur may have been able to avoid some of the £2.6 million tax liability (and consequently the employer could potentially also have saved on National Insurance contributions), if the compensation payment clauses in the agreement had been drafted more clearly.

For example, perhaps if the agreement had expressly apportioned part of the sum being paid to Ms Mathur as injury to feelings compensation for historic acts of discrimination (entirely unrelated to the termination), and clearly distinguished this from other payments being made, those injury to feelings payments may have been payable tax free. 

This would not, of course, have allowed the parties carte blanche to apportion payments (or determine tax treatment) as they wished; the quantum of any injury to feelings compensation would still have been subject to the usual “Vento Bands” (the upper end of the top band for the worst types of discrimination currently sitting at around £56,200), and there would have to be clear rationale for distinguishing them from payments made in relation to discrimination linked to the termination.  However, had such apportionment been made clearer, it may have afforded both parties a little more tax efficiency.

Not just dangers, but opportunities too

Whilst it is tempting to view Mathur v HMRC as a purely cautionary tale (for both employers and employees alike), it also highlights that there are often opportunities for maximising tax efficiency when it comes to the tax treatment of payments in settlement agreements.

Often, the structuring of an exit payment is key to avoiding a protracted dispute with an employee, and so the tax treatment of settlement agreements is of particular strategic importance in any settlement negotiation. There are lots of legitimate opportunities to make tax efficiencies in respect of settlement payments, including:

  1. utilising the £30,000 tax-free termination payment allowance in full;
  2. distinguishing payments which are intended as compensation for allegations of discrimination which are wholly unrelated to the subsequent termination of employment from those which are inextricably linked with it, and clearly setting this out in any agreement;
  3. apportioning a part of the compensation towards legal fees incurred (particularly as in practice the latter usually exceed the token contribution employers usually make under the terms of settlement agreements);
  4. making payments into the employee’s pension fund rather than directly to them (subject, of course, to the rules of the fund in question and any applicable tax-free payment thresholds); and/or
  5. strategically timing the dates the compensation payments are made, to apportion them effectively between tax years and maximise any income tax personal allowance.

Equally, employers need to take care that any tax efficiencies which are made do not fall foul of the applicable tax rules, and do not leave them with an unexpected (and costly) tax liability.

A tax efficient settlement agreement can really ‘sweeten the deal’ for an employee, and make the prospect of settling all the more attractive. This in turn leads to a quicker, cheaper and more amicable resolution to a dispute – avoiding the costly and time-consuming process of proceedings in the Employment Tribunal.

However, as Mathur v HMRC makes very clear, there can also be serious financial consequences if tax obligations are misunderstood.

If you are considering a settlement agreement with an employee, please feel free to contact a member of our Employment team. We would be delighted to discuss how you can make your settlement agreement as attractive and as efficient as possible.


The material in this article is provided for guidance and general information only and is not intended to constitute legal or other professional advice upon which you should rely. In particular, the information should not be used as a substitute for a full and proper consultation with a suitably qualified professional. Please do contact the Bates Wells team if you require further information.