Compensation for future pension rights was taxableby
In this case, the upper tribunal found that the compensation paid to E.ON employees for changes to future pension rights was taxable as earnings.
The past two decades have seen many “defined benefit” occupational pension schemes become less generous in the retirement benefits on offer. These changes are usually to control the actuarially driven costs of funding a guaranteed pension promise against ever-increasing life expectancy and dwindling returns on gilts.
Where there are existing members, any change represents an erosion of those members’ contractual entitlements, which often involves companies making one-off lump sum payments to compensate. The tax and national insurance contribution (NIC) treatment of such payments is a thorny topic that often needs to be settled by the courts.
One such case is E.ON UK plc  EWCA Civ 1383, whose case was recently heard by the court of appeal.
The E.ON pension scheme included a “retirement balance” category, whereby members could elect on a year-by-year basis the percentage of their pensionable earnings that would be credited as a notional sum to their retirement balance account. This credit was partially funded by the member (the balance was met out of the company’s normal actuarial funding). At retirement, the retirement balance account is available to generate a lump sum or purchase a pension.
The changes to the scheme included increases (between 1% and 4%) to the proportion of a credit, which would be funded by the member, and the loss of a facility to make credits in excess of 40% of pensionable earnings.
Following consultations with the unions, E.ON provided an “integrated package” to compensate members for the changes, including:
- a two-year pay deal
- a five-year embargo on any further changes to pension arrangements, and
- a “facilitation payment” of 7.5% of salary, subject to a minimum of £1,000.
Discussions with HMRC led to E.ON operating PAYE and NIC on all but one of the facilitation payments. The single exception (Jason Brotherhood) was to be the subject of an appeal.
Although the tax and NIC in respect of Brotherhood alone was small (£758 of PAYE and NICs of £987), the sum at stake was somewhat greater: facilitation payments totalling £6.48m had been made, and HMRC “agreed that if E.ON succeeded in its appeal it would repay the tax and NICs in respect of all facilitation payments”.
Single fundamental question
The appeal came before the first tier tribunal (FTT), which held that the payments were taxable and subject to NIC.
E.ON appealed to the upper tribunal (UT), which held that the payments were not subject to tax and NIC.
By the time the appeal came to the court of appeal, “ultimately the single fundamental question” was whether the payment was “from” employment (and therefore taxable) or “from” something else. In the opinion of the UT, it was “compensation for adverse changes to rights and expectations in relation to [Brotherhood’s] pension arrangements” and therefore was “from” those pension rights.
A number of settled cases, whose facts and ratios helped shed light on the present matter, were considered and summarised by Lady Justice Falk who gave the lead judgment (with which Lords Justice Nugee and Lewison agreed).
Hunter vs Dewhurst (1932) concerned a company chairman. The company’s articles provided that anyone who had been a director for at least five years was entitled, on retirement, to a lump sum equal to the last five years’ remuneration. The chairman wished to stand down but was persuaded to remain as a director with reduced duties and reduced emoluments. Because this meant that – on his eventual retirement – his lump sum would also be reduced, the company paid him an immediate compensatory amount in full settlement of his rights under that article.
The House of Lords held that the payments were “to obtain a release from a contingent liability under a contract of employment”; they “did not arise from the office of director, but in spite of it”.
Tilley vs Wales (1943) concerned a managing director who had provided his employer with a secret process, for which he was rewarded with a royalty. In time, the royalty was replaced by a salary increase and a pension promise totalling £40,000 over 10 years. Later on, the company wished to rid itself of these obligations and reduced his salary while paying a lump sum of £40,000.
The House of Lords held that the £40,000 was “a sum paid for the release of an obligation to provide a pension”; once again, it was “not from the office of director, but in spite of it”. Furthermore, Lord Porter suggested obiter that, when traced fully back, it “looks much more like a payment in lieu of the stipulated reward for revealing the secret process”.
Mairs vs Haughey (1994) concerned compensation for the loss of rights to a generous redundancy scheme.
The House of Lords held that a “payment made to satisfy a contingent right to a payment derives its character from the nature of the payment which it replaces”. If the employee had been made redundant, he would not have been taxed on the sum he received; therefore a lump sum replacing any right to that redundancy payment was similarly not taxable as employment income: “There will usually be no legitimate reason for treating the two payments in a different way.”
This “replacement principle” should be invoked with caution. In EMI vs Coldicott (1999) the court suggested it was “not necessarily helpful to press [it] too far in this field, where fine distinctions abound” – ultimately all that matters is “whether the amount in question is earnings ‘from’ employment”.
Lady Justice Falk was not convinced that the present case aligned itself with the above cases. In Hunter vs Dewhurst and Tilley vs Wales, the companies already had an obligation to pay a certain amount to the employee “contingent only on his leaving office… [or] doing so other than in prescribed circumstances”.
“In that sense they were accrued rights. That is very different from the facts of this case,” said Falk. In the case of E.ON, the pension rights so far accrued were unaffected by the new arrangements; the facilitation payment related to pension rights that had not yet been accrued.
“The FTT was correct to describe this in terms of an expectation of a future pension rather than giving up any existing right, contingent or otherwise,” she said. The pension scheme would simply become less attractive for the future.
“The package related to the rewards and benefits of future employment with E.ON. It was an inducement to work willingly for the future, which, in line with Shilton vs Wilmshurst (1991) makes it a payment “from” employment.
In the end HMRC’s appeal was upheld, and the facilitation payment was held to be liable to PAYE and NIC.