Buying out employment rights on a TUPE transfer – to tax or not to tax?

A decision of the First-tier Tribunal (“FTT”) has considered the correct tax treatment of a lump-sum payment made to compensate an employee for the loss of pension, share and other contingent rights on a TUPE transfer.

When a TUPE transfer occurs, the employment contracts of all in-scope employees are transferred automatically under TUPE to the new owner of the business (or the new provider of the service) along with all the “duties and liabilities under or in connection with” the contract. Subject to certain specific exceptions set out in TUPE, all of the employees’ terms and conditions should strictly speaking transfer with their employment.

The requirement that everything must remain “as is” when the employees arrive at their new employer’s door has always been problematic. The idea is that nothing is allowed to change for the employees, when in fact a key component of their employment contract clearly has changed – the other party to it! This causes frustration for the receiving employer and changes are often made despite the law. TUPE does not permit harmonisation for harmonisation’s sake, but the commercial desire to avoid a two-tier workforce often takes precedence and employers make changes notwithstanding the risks.

While a new employer might want to implement various different types of contractual changes, the withdrawal of certain benefits which were particular to the old employer is often on the table. There is a risk involved in failing to honour pre-transfer entitlements, but the new employer might nonetheless decide that it does not want the hassle of having to provide benefits which its systems are not set up to administer. Alternatively, the new employer simply may not be able to offer the same benefits - for example, it cannot continue to offer a scheme providing for the grant of share options in the old employer’s parent company. 

But what of those rights and entitlements that are discontinued? Withdrawing them without adequate compensatory measures will give rise to various risks, including the possibility of employees resigning and bringing quasi-constructive dismissal claims, arguing they have suffered a “material detriment”.

As a result, the new employer will often come up with some form of compromise to stop employees feeling disgruntled about these changes. Enrolling the transferred employees into the new employer’s own benefit schemes is the most common approach, but we are increasingly seeing cash being paid to “buy out” the benefit being withdrawn. While this approach is clearly open to challenge and should not be taken without careful consideration of the risks, it is not in any way “illegal”. Indeed, there are even a number of court decisions dealing with how such buy-out payments should be managed when they are used.

The latest of these is the FTT’s recent decision, which concerned the transfer of Mr Reid’s employment under TUPE from BP to North Air. As North Air’s existing benefits schemes were less favourable to Mr Reid than his previous BP benefits, it negotiated a ￡25,787 “buy out payment” with him in return for his surrender of certain entitlements. The formula for calculating the payment had been agreed during consultation and it was made under the terms of a settlement agreement (which included a requirement for Mr Reid to enter into a new contract with North Air).

The FTT confirmed that, where such payments are made as inducements for the employee to remain in employment or accept new employment, they will be taxable as an emolument of employment. However, in this case, the condition of Mr Reid entering into a new contract was simply the trigger for the payment. It was made as a “lump sum in lieu of contingent rights” and for tax purposes should be treated in the same way as the rights it was replacing. 

The FTT therefore concluded that the part of the payment which replaced contingent pension rights was not taxable as earnings. The other elements of the payment (in respect of shares, bonus and lunch allowance) were, however, subject to tax in the usual way (as they would have been when Mr Reid was employed by BP).

As the obligation to deduct tax sits with the employer - and HMRC will usually seek to recover underpaid tax from the employer in the first instance - this case is a useful reminder of the need to analyse any buy-out payments carefully before determining how they should be taxed. Assuming that they are compensation/damages payments only could lead to an unexpected bill further down the line.

Reid v HMRC [2016] UKFTT 0079 (TC) – judgment available here