In Keith Murphy v HMRC  UKUT152, the Upper Tribunal (UT) treated the costs of an employment claim settled by the employer as non-taxable. They were not earnings derived from the taxpayers’ employment, they were necessary costs of making the claim. This decision was overturned upon appeal to the Court of Appeal.
Mr Murphy was a police officer with the Metropolitan Police Service (the Met).
- He and other officers had received payments under a settlement agreement in respect of claims brought for alleged unpaid overtime and other hardship allowances.
- The settlement (‘the Principal settlement sum’) included compensation, agreed costs and legal expenses and the costs of insuring against liabilities to pay the Met’s legal costs if the claims proved unsuccessful (‘the disputed costs’). The legal costs were on a success fee basis. The disputed costs were to be paid by the Met directly whereas the agreed costs were settled by Reimbursement by the employer.
- The Met considered that the entire settlement amount including the costs it paid direct were employment income on which Income Tax and national insurance were due, proposing to deduct tax accordingly. They agreed to cooperate with any claimant who challenged the tax treatment of the settlement amount. No tax was deducted.
- Mr Murphy excluded the settlement amount from his tax return considering the total amount to be non-taxable. HMRC raised Discovery assessments on the total amount with no deduction for the success fee or insurance costs. Mr Murphy made an appeal.
- The First Tier Tribunal (FTT) agreed with HMRC deciding that Mr Murphy was subject to Income Tax on all the amounts received under the settlement agreement, including those that were used to pay the success fee and insurance costs. This was on the basis that the amounts were employment income and were ‘other profit’ obtained by the employee’ under s.62(2)(b) ITEPA 2003. Mr Murphy appealed.
The Upper Tribunal (UT) allowed the appeal granting deductions for the disputed costs.
- The question was as to the meaning of ‘profit’ in s.62(2)(b), whether this should be taken net or gross and whether it derived from the employment.
- The parties had agreed that the agreed costs were not taxable as employment income. They were over and above the compensation amounts, were not a reward for services and even if they were derived from employment they did not make the claimants better off, so were not profit under s.62(2)(b).
- The UT applied the same analysis to the disputed costs. There was no reason to treat them differently. Even if they were profits derived from the employment, they should be deducted in the calculation of the net profit received by the claimants. They were necessarily incurred in order to obtain compensation because Met had not paid the full amounts that they were owed for their employment.
- The FTT had erred in law. Mr Murphy did not make a profit within s.62(2)(b) to the extent that the Principal Settlement Sum was paid in discharge of the legal success fees and insurance premiums. Those amounts should not be treated as earnings of Mr Murphy under s.62 ITEPA.
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