Repayment Clauses in Compromise Agreements

(Thanks to Neil Russell of BD Laddie, and to Michael Simpson of Thompsons, for telling me the official guidance was out)

On 26th August 2003, I gave advance notice of the Inland Revenue's intention to issue a formal statement on its attitude to repayment clauses in compromise agreements.

The statement has now been issued in issue 67 of the Tax Bulletin. It is reproduced below; but, in summary, the Revenue accepts that sums paid which are repayable in certain circumstances are not taxable.

TAX BULLETIN 67

Termination payments and benefits - repayment clauses in compromise agreements - application of s225-6 ITEPA 2003

In recent months, a question has arisen concerning whether the existence of a "repayment clause" in a compromise agreement made at termination of employment gives rise to a charge to tax and National Insurance Contributions under the legislation dealing with restrictive covenants (s225-6 ITEPA 2003 - formerly s313 ICTA 1988 - and s4(4)(b) Social Security Contributions and Benefits Act 1992).

Typically, such a clause requires the employee to repay some or all of the sum settled by the agreement if he or she subsequently initiates litigation in respect of the employment or its termination.

The Revenue's view has been, and remains, that a compromise agreement by its very nature includes a restrictive covenant. This is because the employee agrees not to do something, namely not to commence or continue litigation.

Statement of Practice 3/1996 advises that the Revenue will not attribute any of the settlement sum to such an undertaking, so there is nothing to charge under s225-6 ITEPA 2003.

However, an employer could still make a payment specifically for an undertaking not to litigate, in which case SP 3/1996 would not apply and a charge arises.

The question is whether a repayment clause entails attribution of some or all of the settlement sum to that undertaking since the sum is lost if litigation commences.

Following legal advice, the Revenue accepts that such a charge will not arise other than in very exceptional cases.

Vaughan-Neil v CIR (54 TC 223) confirmed that it is necessary to establish, realistically and as a matter of fact, what the settlement sum is actually paid for. Normally, a compromise agreement made at termination deals with genuine claims and the settlement sum is paid in consideration for settling those claims. Where that is the case, the settlement sum is exhausted by reference to those claims and no sum remains to be attributable to the undertaking not to litigate. That remains the case whether or not a repayment clause exists.

Consequently, enquiries will not normally be raised on this point alone. The Revenue will raise the question only if the claims appear spurious, for example the amounts are clearly in excess of a reasonable sum for settlement of the claims.

Practitioners should bear in mind that there are no tax or NIC provisions allowing adjustment to charges if such a repayment in fact happens.

All the NICs legislative references mentioned in this article are those which apply in Great Britain. Northern Ireland has its own NICs legislation which, in the main, is the same as that for Great Britain