Tax treatment of the payment of legal fees under a compromise agreement

HM Revenue & Customs (“HMRC”) has published draft regulations which give a legislative footing to the existing extra-statutory concession which allows employers to pay a former employee’s legal fees tax free under a Court order or compromise agreement. However, there are concerns that, as drafted, some payments which can currently be paid tax free under the concession will not benefit from this exemption in future.

At present, where an employer pays an employee’s legal costs on termination of employment, it can do so free of tax if they are paid:

• under a specific term of a compromise agreement between the parties, provided that the payment is made by the employer direct to the former employee’s solicitor and relates to costs only incurred in connection with the termination of employment; or

• in accordance with a Court or Tribunal order, even if paid directly to the former employee.

The new regulation, which has not yet been enacted, is intended to have effect for payments made on or after 6 April 2011. The concession will be formally withdrawn once the new regulation comes into force.

However, there is a concern that if the regulation is enacted as currently drafted certain payments which currently benefit from the exemption will cease to do so. As drafted, the exemption will apply where the legal costs are incurred exclusively in connection with the termination of employment and the payment is made pursuant to a Court or Tribunal order (including payments directly to the former employee) or is made directly to the former employee’s solicitor under the terms of a compromise agreement which complies with section 203 of the Employment Rights Act 1996.

Whilst many compromise agreements will cover claims under the Employment Rights Act 1996 and comply with section 203 of the Employment Rights Act 1996, this is not always the case. For example, a compromise agreement may be limited to claims under the Equality Act 2010 or the Trade Union and Labour Relations (Consolidation) Act 1992. Further, the draft regulation does not extend to legal fees paid in connection with a COT3 agreement reached through Acas conciliation.

We understand that HMRC has received representations on these issues and so the draft legislation may be amended to bring these arrangements within the exemption. However, employers should confirm the position before making payments of legal fees on a tax free basis on or after 6 April 2011 in circumstances which are not currently covered by the draft legislation.

(The new regulation, which will replace extra-statutory concession ESC A81, is expected to be Regulation 10 of the Enactment of Extra-Statutory Concessions Order 2011.)