Taxation of payments to commute future pension benefits

The Court of Appeal has held that a payment made to employees in part to compensate for changes to their future pension scheme rights were earnings from their employment and so subject to income tax and NICs: HMRC v E.ON UK Plc [2023] EWCA 1383. The Court rejected the arguments that the payment replaced tax-free pension contributions and so should be free from tax and that the House of Lords decision in Tilley v Wales was authority that a payment to compensate for the loss of future pension rights was not taxable as earnings. In essence, the payments were simply an inducement to continue to provide their services in the future under altered employment conditions and taxable as such.

More generally, the decision cautions against an over-zealous application of the "replacement principle" (taxing a payment on the basis of the treatment of  payments it replaces), both on the grounds that it can be difficult to discern exactly what the payment replaces (as in this case where it was part of a package of measures) and on the basis that it is not necessarily clear that statutory provisions applying to a particular type of earnings would automatically apply to a payment that replaces such earnings.  

Background

In 2019, E.ON entered into negotiations with employees to make various changes to their employment rights. In return for agreeing to unfavourable changes to their defined benefit (DB) pension entitlements, employees received a package including guaranteed pay rises and a one-off facilitation payment. The changes did not affect any accrued pension rights, only the basis on which future pension rights accrued.

E.ON contended that the facilitation payment was not taxable as it was compensation for loss of pension rights and the House of Lords decision in Tilley v Wales was authority that such a payment was not taxable as earnings. Furthermore, E.ON argued that the payment was not taxable under the "replacement principle" established in Mairs v Haughey because it replaced a non-taxable sum.

The FTT rejected those arguments. It held that Tilley v Wales only applied to giving up an existing accrued right rather than an expectation to future pension rights. In addition, the FTT rejected the argument that the payment replaced non-taxable earnings. Rather, if anything, it replaced the shortfall in pay which employees would experience if they wished to maintain their existing level of benefits (by making further pension contributions).

On appeal, the Upper Tribunal overturned the FTT decision. It held that the FTT had read the ratio of Tilley v Wales too narrowly and that it did apply sums paid in respect of a diminution of expected future benefits.

Decision of the Court of Appeal

The leading judgment of Falk LJ in the Court of Appeal has undertaken an in-depth analysis of the decision in Tilley v Wales and the earlier House of Lords decision in Hunter v Dewhurst which was relied on in that case. Hunter v Dewhurst involved a company chairman entitled to a payment on termination of employment of five years salary. Rather than resigning, he was persuaded to stay on the board at a significantly reduced salary and in return received a payment as if he had resigned but waived any future entitlement to a termination payment. Tilley v Wales concerned a lump sum payment of £40,000 made to an employee in return for him accepting a lower salary and foregoing his right to a pension of £4000 for 10 years on termination of his employment. In both cases, it was found that the sums paid were not earnings from the employment.

The Court of Appeal has held that the true ratio of Tilley v Wales is that it is limited to a payment received in commutation for an accrued right to a pension payment contingent only on the employee leaving office. That was very different to the facts of this case, which did not affect accrued pension rights at all. What was affected was pension benefits related to future service with E.ON, that is an expectation of future pension rather than giving up any existing rights. E.ON's DB scheme would simply be less attractive for the future. (In doing so, Falk LJ disagreed with the observations of Hellier J in Kuehne + Nagel that the removal of an expectation of a pension should be treated in the same way as a sum paid in exchange for a vested pension right.)

The Court of Appeal has also cautioned against pressing the replacement principle too far. In this case, it was far from obvious what the facilitation payment replaced. E.ON argued that it replaced employer contributions to the DB scheme, but the Court of Appeal noted that it could equally be seen as replacing the lower retained earnings that would be suffered in order to maintain the same level of benefits (as the FTT had found). In any event, the Court of Appeal noted that even if they did replace employer contributions, these benefit from an express statutory exemption and it was far from clear that replacement payments would fall within that statutory exemption.

Falk LJ also suggested that Tilley v Wales could be seen as reflecting the replacement principle, "not by according the lump sum the same tax treatment as the pension it replaced, but by  its tax treatment being sufficiently coloured by the nature of what it replaced to prevent it being treated as "from" employment".

It was also relevant that the payment was part of a broader package, which emphasised the forward looking nature of the overall agreement. The package related to rewards and benefits for future employment with E.ON. It was an inducement to work in the future and such inducements have been found to be taxable in cases such as Shilton v Wilmhurst.

In a separate judgment in agreement with Falk LJ, Lord Nugee noted in circumstances where employees are being asked to agree a change in their terms and conditions on which they are employed in the future, and in return receiving a payment, it appears plain that the payment is from their employment. It made no difference that the payment was made in connection with changes to a DB pension scheme. Equally, there was nothing in the authorities to require a different approach. Tilley v Wales goes not further than holding that a sum in commutation of accrued pension rights is not taxable as earnings from employment. Lord Nugee also considered Hunter v Dewhurst a "difficult case" and would have supported the dissenting speeches in that case had he been free to do so. However, Lord Nugee was content to accept that it too was limited to "a sum of money paid by the company to obtain release from a contingent liability".

Comment

Determining whether a payment is "from" employment can be difficult. In this context, the Court's confirmation of the scope of Tilley v Wales is important in confirming that it is limited to accrued but contingent rights only. Perhaps just as important is the note of caution provided by the Court as to the application of the "replacement principle". The only question is whether the actual payment concerned arises from the employment and it is important not to press the application of the "replacement principle" too far in this context where fine distinctions abound.