19 Aug 2022

Murphy: tax implications of cost (non-)recovery

Insights, Publications

You successfully sue your employer for remuneration owed to you.  What you receive is usually taxable as earnings (there’s potentially a limited exception to the principle, but that’s for another day).  Anything that you recover as a contribution to your costs isn’t earnings and isn’t taxable.  But to the extent that you don’t recover costs and have to bear them yourself, you don’t get tax relief for them.  As tax concepts go, it’s not difficult.

In the case of Murphy v HMRC, the First-tier Tribunal (‘FTT’) got it.  The Upper Tribunal (‘UT’) didn’t.  The Court of Appeal has just set them right, in [2022] EWCA Civ 1112.

Murphy was a policeman who, along with others, sued the Metropolitan Police (‘the Met’) for overtime and other payments.  The Met agreed to pay out £4.2m plus ‘Agreed Costs’.  These were defined as the legal costs and disbursements of the claimants’ solicitors and counsel.  But the agreement provided explicitly that the Met weren’t liable for payments which the claimants were committed to make under a ‘Damages-Based Agreement’ (essentially a percentage ‘success fee’ payable by the claimants to their lawyers) or an insurance premium insuring against the risk of paying the Met’s costs if the claim failed.  Payment of those items remained the responsibility of the claimants – though as a matter of mechanics they were paid on behalf of the claimants by the Met, who paid over to the claimants only the net amount after deducting these amounts.

There was no dispute about the tax treatment of the Agreed Costs: they weren’t earnings.  The question was whether the claimants were liable to tax on the full £4.2m or only on the lesser amount they actually received.

The FTT had no real difficulty with the case.  The £4.2m did not include costs – it was wholly a payment in settlement of a claim for unpaid allowances and overtime which would have been taxable earnings if they had been paid in the first place.  The fact that some of it was paid away with the agreement of the claimants to discharge their liabilities did not change that.  The full £4.2m was taxable as earnings.

Before the UT, it was agreed that the taxability of the £4.2m depended on its being a ‘profit…obtained by the employee’.  To the extent that the £4.2m reimbursed expenses incurred in securing it, it was not ‘profit’.  So only the net amount after deducting the insurance premium and the success fee was taxable.

In the view of the Court of Appeal, the UT got it wrong.  In the context of defining earnings, ‘profit’ does not mean ‘net profit’: rather, the word is used in the sense (quoted from the Oxford English Dictionary) of “a material benefit derived from a property, position, etc; income, revenue.”

The Court of Appeal summarised the position thus:

The position in this case was no different from any other case in which the taxpayer is left to defray some or all of his costs and disbursements in the litigation out of the damages or compensation he receives. If, as in the present case, he is paying those costs and disbursements out of money which represents his taxable income from employment, the whole of the money which represents his taxable income remains taxable. Therefore the Met was right to deduct PAYE from the whole of Mr Murphy’s share of the [£4.2m].

Quite.

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