Taxation of settlement payment
In the next case, a compromise agreement, entered into at the end of a protracted mediation, failed to stipulate whether the compensation payment was payable gross or net of income tax and in the litigation that resulted a court had to rule whether the former employer acted correctly by deducting tax before making the payment to the ex-employee.
The facts were that an employee and his former employer reached a settlement negotiated through mediation. The crucial clause in the agreement prepared to record the settlement terms stated that ‘[The Employer] shall by 4pm on 1 November 2012 pay £1,350,000 (the Settlement Sum) by telegraphic transfer into the [the Employee’s solicitors’ bank account]’ but was silent about whether the sum was to be paid gross or net of income tax.
The Employer deducted tax at 50% from the settlement sum which it paid to HMRC and paid the net sum of £676,822.84 directly into the Employee’s solicitors’ bank account.
The Employee asked the court to order the Employer to pay him a further £676,822.84 representing the tax it had deducted. He argued that under the terms of the agreement the Employer was obliged to pay the full gross sum of £1.35 million to his solicitors' bank account, and to pay another £1.35 million to HMRC representing tax due on the settlement sum. The Employer contended that they were entitled, indeed obliged by law, to pay only a net sum having deducted PAYE income tax.
Both parties tried to introduce evidence of their intentions when the settlement was agreed. However, the court ruled that the correct interpretation of the contract was objective and not one based upon the subjective knowledge or intentions of the parties. In the court’s view, the correct interpretation of the relevant clause in the agreement was very simple. Sums paid in connection with employment attract income tax. Income tax must in all normal circumstances be paid by way of PAYE by the employer on behalf of the employee. It is common for an employment contract to provide that the employee's salary is £x per month. No employer or employee actually expects the gross sum of £x to be paid every month. Instead, it would be understood by any objective observer, reading the employment contract, that the amount to be paid would be £x less the income tax due from the employee to HMRC which is to be paid by the employer on the employee's behalf.
Both parties were represented at the mediation by solicitors and it seems almost inconceivable that they made a basic error in not stating in the compromise agreement whether the settlement sum was payable gross or net of tax. Although the court ultimately dismissed the Employee’s argument that he was entitled to receive the payment without deduction of tax as absurd, the failure to spell out in the agreement that the payment was net of tax resulted in expensive court proceedings.
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