Case of the final bonus: Should it be taxed?
A bonus paid after the employment is terminated doesn’t make that bonus part of the termination payment, and thus potentially within the £30,000 tax-free cap.
In T Lucas v HMRC (TC07809) the first tier tribunal (FTT) had to consider whether a bonus paid to an employee whose employment had already been terminated was a termination payment, and if so, whether it benefited from the £30,000 tax-free threshold.
The tax years under consideration were 2011/12 to 2016/17. The case was therefore decided on the rules that applied up to 6 April 2018, when the rules on the tax treatment of payments made under the termination payments were changed.
Lucas worked for large international bank between 1 November 2010 and 18 July 2012, when his employment was terminated by mutual agreement. The appeal concerns a guaranteed bonus he received in subsequent years. Lucas contended that the bonus should be taxed as a termination payment, whereas HMRC contended that the bonus represents earnings from the employment, taxable under ITEPA 2003, s62.
Earnings or termination payment?
The key issues the FTT had to decide were:
- whether the payments received by Lucas were termination payments within ITEPA 2003, s401 or general earnings within ITEPA 2003, s62; and
- if the payments are general earnings, whether (under ITEPA 2003, s16 which determines the year for which general earnings are earned) they were earnings for 2011/12 or 2012/13.
Lucas contended that the bonus payments were made under the compromise agreement he signed with his employer on 23 April 2012 and, as such, should be taxed as termination payments under ITEPA 2003, s401. As a result, the bonus payments were exempt from tax as they fell within the £30,000 tax-free threshold.
HMRC contended that the bonus payments were earnings from Lucas’ employment and, as such, were taxable under ITEPA 2003, s62 as general earnings. The bonus was earned in October 2011.
Lucas was initially informed that his employment was to be terminated “with cause”; however, agreement was reached to terminate the employment by mutual consent, as reflected in the compromise agreement. This preserved his entitlement to the bonus.
As the bonus was earned in October 2011, it would be taxed in 2011/12, with overseas workday relief (OWR) applying to the extent that his earnings related to duties performed overseas.
The tribunal found that had the bonus been paid in the course of Lucas’s continuing employment, it would have “clearly and undoubtedly” been earnings from the employment. The tribunal found no merit in Lucas’s contention that the bonus was not “salary, wages or fee” (within ITEPA 2003, s62(2)(a)) and that if it was not a salary, it was clearly “anything else that constitutes an emolument of the employment” (within ITEPA 2003, s62(2)(c)).
The tribunal noted that had Lucas’s employment been terminated “for cause” rather than by mutual consent, he would have forfeited the bonus.
But with the entitlement preserved, the tribunal found the bonus fell squarely within ITEPA 2003, s62 and was taxable as earnings; consequently, there was no need to consider ITEPA 2003, s401 (taxation of termination payments).
Earnings are charged to tax in the year in which they are received. Although the bonus was paid over a number of years and taxed in those years, it was “earned” in October 2011 and therefore represented earnings for the year to 2011/12, with OWR being applied as appropriate.
Although this case was decided under the rules that applied to termination payments prior to 6 April 2018, there are some general lessons that still apply today.
The fact that an employment is terminated does not change the character of a payment made in the normal course of that employment. A payment of earnings which relates to a continuing employment is taxed as earnings and does not form part of the termination award. A subsequent termination of the employment does not change that.
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Sarah Bradford BA (Hons) FCA CTA (Fellow) is the director of Writetax Ltd (www.writetax.co.uk) and its sister company, Writetax Consultancy Services Ltd. She writes widely on tax and National Insurance contributions and is the author of National Insurance Contributions 2020/21 published by...