Keith Murphy v The Commissioners for HMRC

Introduction 1. This is an appeal by Mr Keith Murphy from a decision of the First-tier Tribunal (Judge Guy Brannan) (the “FTT”) released on 11 November 2020 (the “FTT Decision”). The respondents are the Commissioners for Her Majesty’s Revenue and Customs (“HMRC”). 2. Mr Murphy was a police officer with the Metropolitan Police Service (the “Met”). The matter before the FTT concerned the tax treatment of certain payments made by the Met for the account of Mr Murphy and a number of other police officers pursuant to a settlement agreement in respect of claims brought by the officers for alleged unpaid overtime and other allowances. The disputed payments related to certain legal expenses and the costs of insurance against liabilities to pay the legal costs of the Met if the claim were to be unsuccessful. 3. The FTT decided that Mr Murphy was subject to income tax on the amounts received from the Met pursuant to the settlement agreement that were applied to make the disputed payments. This was on the basis that such amounts were employment income. Mr Murphy now appeals to this Tribunal with the permission of the FTT. Relevant legislation 4. It will assist our explanation if we first set out the legislative background to this appeal. 5. The charge to income tax on employment income is contained in s6 of the Income Tax (Earnings and Pensions) Act 2003 (“ITEPA”). It provides, so far as relevant: 6 Nature of charge to tax on employment income (1) The charge to tax on employment income under this Part is a charge to tax on— (a) general earnings, and (b) specific employment income. The meaning of “employment income”, “general earnings” and “specific employment income” is given in section 7. (2) The amount of general earnings or specific employment income which is charged to tax in a particular tax year is set out in section 9. … 6. Section 6 ITEPA therefore charges income tax on “general earnings” and “specific employment income”. The concept of “specific employment income” encompasses amounts which count as employment income under certain specific regimes, such as the rules relating to securities and securities options and the disguised remuneration rules. It is not relevant for present purposes. 7. The definitions of “employment income” and “general earnings” are found in s7 ITEPA. It provides as follows: 7 Meaning of “employment income”, “general earnings” and “specific employment income” (1) This section gives the meaning for the purposes of the Tax Acts of “employment income", “general earnings” and “specific employment income”. (2) “Employment income” means— (a) earnings within Chapter 1 of Part 3, (b) any amount treated as earnings (see subsection (5)), or (c) any amount which counts as employment income (see subsection (6)). (3) “General earnings” means— (a) earnings within Chapter 1 of Part 3, or (b) any amount treated as earnings (see subsection (5)), excluding in each case any exempt income.… … 8. Subsection (5) contains references to amounts which are treated as earnings, for example, under the rules relating to agency workers or workers under arrangements made by intermediaries or the benefits code. It is not relevant for present purposes. 9. Subsection (6) concerns amounts which are treated as specific employment income. It is also not relevant for present purposes. 10. The amount of general earnings which is charged to tax in a particular tax year is set out in s9(2) ITEPA: 9 Amount of employment income charged tax … (2) In the case of general earnings, the amount charged is the net taxable earnings from an employment in the year. 11. The “net taxable earnings” of an employee is given by a formula which is set out in s11(1) ITEPA: 11 Calculation of “net taxable earnings” (1) For the purposes of this Part the “net taxable earnings” from an employment in a tax year are given by the formula— TE − DE where— TE means the total amount of any taxable earnings from the employment in the tax year, and DE means the total amount of any deductions allowed from those earnings under provisions listed in section 327(3) to (5) (deductions from earnings: general). … 12. The meaning of “earnings” for these purposes is found in s62 ITEPA. It provides: 62 Earnings (1) This section explains what is meant by “earnings” in the employment income Parts. (2) In those Parts “earnings”, in relation to an employment, means— (a) any salary, wages or fee, (b) any gratuity or other profit or incidental benefit of any kind obtained by the employee if it is money or money's worth, or (c) anything else that constitutes an emolument of the employment. (3) For the purposes of subsection (2) “money’s worth” means something that is— (a) of direct monetary value to the employee, or (b) capable of being converted into money or something of direct monetary value to the employee. (4) Subsection (1) does not affect the operation of statutory provisions that provide for amounts to be treated as earnings (and see section 721(7)). Facts 13. We have set out below a summary of the facts which are relevant to this appeal. It is drawn largely from the FTT Decision (FTT [5]-[24]). The facts were not in dispute before the FTT or before us. 14. On 19 December 2014, Mr Murphy and other police officers commenced group litigation proceedings in the High Court against the Met for unpaid overtime and other allowances (“hardship allowances”). A number of other police officers were added as claimants at a later stage. We refer to Mr Murphy and the other claimants in the legal proceedings together as the “Claimants”. 15. To fund the legal proceedings against the Met, each of the Claimants entered into a Damages-Based Agreement (the “DBA”) with a firm of solicitors, Simons Muirhead & Burton (“SMB”), and Jonathan Davies of Counsel. Under the terms of the DBA, SMB and Jonathan Davies agreed to act as solicitors and counsel respectively for the Claimants in return for a “Success Fee” which was calculated as a percentage of any sum paid by the Met to settle the claim or any damages awarded to the Claimants by the High Court. The percentage was originally set at 40%, but was subsequently reduced by agreement to 30% and the maximum amount by reference to which the fee operated was capped at £4 million. 16. Each of the Claimants also entered into an insurance contract with Temple Legal Protection Limited (“Temple”). Under the terms of the insurance contract, Temple insured the Claimants against the risk of having to pay the Met’s legal costs if the Claimants lost all or part of their claim in return for a premium. 17. The Met denied any liability for the overtime or hardship allowances claimed by the Claimants. 18. On 5 May 2016, the Met entered into a settlement agreement (the “Settlement Agreement”) with the Claimants. We summarize the main provisions of the Settlement Agreement below. The recital to the Settlement Agreement, under the heading “Background” stated as follows: The Claimants lodged a claim in the Queen's Bench Division … on 19 December 2014… claiming pay for unpaid overtime, an entitlement to receive the [hardship allowances] and a declaration regarding the entitlement to the payment of unpaid overtime and [hardship allowances]. The Defendant disputed that the Claimants were entitled to any part of the Claim. A three-day liability trial is scheduled to take place as early as 9 May 2016 (the “Dispute”). The Parties wish to settle the Dispute and have agreed terms for the full and final settlement of the Dispute and wish to record those terms of settlement, on a binding basis, in this agreement. Under clause 3.1 of the Settlement Agreement, the Met agreed to pay the Claimants the sum of £4.2m (which was referred to as the “Principal Settlement Sum”) plus Agreed Costs in full and final settlement of the “Settled Claim”. It was in the following form: 3.1 In exchange for the Claimants agreeing to the full and final settlement of the Settled Claim, the Defendants shall pay to the Claimants a total sum of: (a) £4.2 million (“Principal Settlement Sum”); plus (b) Agreed Costs. The “Settled Claim” was defined in clause 1 as “the claims for payment of [the hardship allowances] from the period of 1 April 2012 until the date of issue of the claims; and the claims for declarations regarding the entitlement to the payment of unpaid overtime and [the hardship allowances]; and any claim for the payment of overtime from the date of issue of proceedings until the date of settlement; and any claim for the payment of [hardship allowances] from the date of issue of proceedings until the date of settlement.” “Agreed Costs” were defined (also in clause 1) as “the legal costs and disbursements plus VAT of the Claimants’ solicitors and counsel as assessed by the court or as agreed with the Met”. The aggregate of the Principal Settlement Sum and the Agreed Costs was referred to in the agreement as the “Global Settlement Sum” (clause 3.2). Under clause 3.3 of the Settlement Agreement, the Met agreed to pay the Global Settlement sum in the following manner: The Defendant [the Met] agrees to pay the Global Settlement Sum as follows: (a) the Firm [SMB] will raise an invoice in the total sum of £1,200,000 ("being the Success Fee") addressed to the Claimants but stated to be payable by the Defendant, which will identify the amount payable to the Firm and to counsel as agreed with the Claimants pursuant to the funding arrangement in place with the Claimants. Only once the Defendant has received this invoice will it pay the Success Fee by electronic transfer to the Firm's office account … within 12 days of the date on which this agreement is signed by both Parties or the Defendant receives the invoice, whichever is later; (b) from the balance of the Global Settlement Sum, the Defendant will deduct £50,000 representing the insurance premium payable to Temple Legal Protection Limited (“Temple”) pursuant to an insurance contract between each of the Claimants and Temple. The Defendant will agree to pay this sum to Temple within 12 days of the date on which this agreement is signed by both Parties or the Defendant receives a letter from Temple confirming the amount of the insurance premium due, whichever is later; (c) from the remaining balance of the Global Settlement Sum, the Defendant will pay to each of the Claimants as contained in an Apportionment Spreadsheet sent to the Defendant by the Firm, such sums to be subject to the withholding of income tax and National Insurance contributions. For the avoidance of doubt, the said withholdings are to be made on the basis of the Principal Settlement Sum and not the balance of the Global Settlement Sum. The payments to be made pursuant to this clause 3.3(c) are to be made in the first monthly payroll which follows receipt by the Defendant of the Claimants' Apportionment Spreadsheet. As can be seen from the above, under clause 3.3(c) of the Settlement Agreement, the Met proposed to treat the whole of the Principal Settlement Sum as being subject to income tax and National Insurance contributions and to deduct tax accordingly. Under clause 7.1, the Met agreed to co-operate with any of the Claimants, who disputed the Met’s proposed tax treatment. Clause 7.1 was in the following terms: 7.1 The Defendant agrees to provides prompt co-operation with any of the Claimants listed in Schedule 1 to this agreement or their representatives in the event that any of the Claimants wish to dispute the Defendant's proposed tax treatment of the Principal Settlement Sum, such co-operation to include, non-exhaustively, providing access to relevant paperwork at no cost to the Claimant(s) and answering questions raised by the Claimant or their representatives or Her Majesty's Revenue & Customs (“HMRC”) relating to the taxation of the Principal Settlement Sum. Such co-operation to be provided by or on behalf of the Defendant promptly and without unreasonable delay. Under clause 5.1 each party released the other party from all claims in relation to the dispute and the Settled Claim. Clause 8.1 dealt with costs and provided: 8.1 Other than the Agreed Costs, the Parties shall each bear their own legal costs in relation to the Dispute and this agreement. No admission of liability to pay overtime or hardship allowances was made by the Met (clause 11). 19. The Principal Settlement Sum was apportioned between the Claimants on the basis of length of service since 20 December 2008 (overtime claim) and 1 April 2012 (hardship allowances claim). No distinction was made between those Claimants who were entitled to overtime and those who were not because they were not inspectors. 20. The FTT also referred to a memorandum dated 29 April 2016 from SMB to the Claimants. This memorandum was written in advance of the settlement of the claims pursuant to the Settlement Agreement and discussed the advantages and disadvantages of the proposed £4.2 million settlement amount. In paragraph 4, the memorandum stated: However, the Met has informed us that it will tax the entire amount of the settlement sum (i.e. it will tax the success fee) and after that, it will deduct the success fee which is payable to your legal team. This approach is less tax efficient for you. This would decrease the size of the pot available to the Claimants. We have told this to the Met and in reply the Met has increased its settlement offer to £4.2 million plus costs. We sought independent tax advice from a tax specialist Barrister …. The tax Barrister has advised that the success fee and legal costs are not taxable. In effect, his position reflects your legal team's position and this is good news. We have sent this advice to the Met. However, what it risks is that the Met may decide to reduce its offer from £4.2 million to £4 million plus costs if it decides to follow the tax advice and NOT tax the success fee. If this does happen, the Executive Committee has authorised me to confirm that they recommend you agree to settle at £4 million plus costs. 21. Mr Murphy filed his 2017 tax return on the basis that none of the Principal Settlement Sum was his income for that year. 22. The tax return was made following correspondence between Mr Murphy's advisers and HMRC in which HMRC stated that the Principal Settlement Sum was not income of the 2017 tax year and should be spread over the period in respect of which the claims were made. 23. HMRC opened an enquiry into Mr Murphy’s tax return but on 12 March 2018 issued a closure notice making no amendments to the return. Also, on 12 March 2018, HMRC raised discovery assessments for the tax years 2009 to 2016. The discovery assessments assessed Mr Murphy to income tax on his apportioned share of the Principal Settlement Sum (without deducting a share of the Success Fee and insurance premium) and to interest. 24. Mr Murphy appealed to the FTT against the discovery assessments on two grounds. The first ground was that the payment of Mr Murphy’s apportioned share of the Success Fee and insurance premium was not his earnings. The second ground was not pursued before the FTT. The FTT Decision 25. Having reviewed the relevant authorities, the FTT defined the question before it as whether the payment of the Success Fee and the insurance premium arose from Mr Murphy’s employment or from something else (using the language of Lord Reid in Laidler v Perry (Inspector of Taxes)[1965] 2 All ER 121 (“Laidler”) at p124) (FTT [51]). 26. The FTT decided that the payment of the sums in respect of the Success Fee and the insurance premium arose from Mr Murphy’s employment and not from something else and accordingly that those amounts were taxable as employment income (FTT [52], [58]). On that basis, it dismissed Mr Murphy’s appeal. 27. The FTT’s reasons for its conclusion were based primarily on the terms of the Settlement Agreement. It was clear from the definition of “Settled Claim” that the claims for unpaid overtime and hardship allowances were made by the Claimants against their employer. If those payments had been made by the Met, they would have been taxable as employment income. The payment of the Principal Settlement Sum and the Agreed Costs was made in satisfaction of that claim (FTT [53]). Whilst it was agreed between the parties that the amount paid in respect of Agreed Costs was not taxable as earnings because it was paid “in respect of something else – i.e. the costs incurred in the action” (FTT [54]), it was clear from clause 8.1 of the Settlement Agreement that the payment of the Principal Settlement Sum did not include any amount in respect of costs, but rather was a payment in settlement of the claim for unpaid overtime and allowances (FTT [55], [56]). The FTT drew some parallels with the judgment of Finlay J in Eagles v Levy(1934) 19 TC 23 (“Eagles”) in this respect (FTT [57]). The full amount of the Principal Settlement Sum was therefore taxable as employment income. The fact that part of that sum (the Success Fee) was then “paid away” to discharge the Claimants’ own liabilities to the solicitors and counsel under the DBA did not affect that treatment (FTT [58]). The same analysis applied to the payment in respect of the insurance premium (FTT [59]). The Grounds of Appeal 28. Mr Murphy appeals to this Tribunal. In summary, his grounds of appeal are that the FTT erred in deciding that the payments of the Success Fee and the insurance premium were Mr Murphy’s earnings for the purposes of s62 ITEPA. His grounds of appeal make three points in support of this position. First, the FTT erred in finding that the Success Fee and the insurance premium arose “from” Mr Murphy’s employment. The Success Fee and the insurance premium arose from the litigation with the Met and the Settlement Agreement and not Mr Murphy’s employment with the Met. Second, the FTT erred in not having due regard to the comments of Lord Denning in Hochstrasser (Inspector of Taxes)v Mayes [1960] AC 396 (at p396-7) (“Hochstrasser”) to the effect that a payment to an employee in respect of a liability incurred in consequence of his employment did not give rise to a “profit” for the employee. Third, the FTT erred in finding that no part of the Principal Settlement Sum was in respect of costs i.e. the Success Fee and the insurance premium (FTT [56]). In doing so, the FTT failed to have proper regard to the comments of Viscount Simmonds in Hochstrasser (at p390) that the question of whether an employee receives a profit from their employment is a matter of substance and not form.