When employees receive a lump sum to compensate them for loss of a benefit at work, they don't expect to pay tax on it. So it's good news for employees that the High Court has just confirmed - in the case of Wilson (HM Inspector of Taxes) v Clayton (2004, IRLR 611) - that they don't have to.

The employees in this case were backed by Thompsons.

What were the facts?

Stephen Clayton was an employee of Birmingham City Council. Under his contract, he was entitled to receive an essential car user allowance. In order to make savings, however, the council decided in 1997 to withdraw the allowance from anyone doing less than 3,000 miles a year.

They wrote to all the relevant employees (including Mr Clayton) asking them to give up their right to the allowance. The letter made clear that if they did not, their contracts would be terminated and they would be offered a new contract identical to the old one, but without the car user allowance.

Not surprisingly, Mr Clayton, along with a number of other employees, refused. As a result, his contract of employment was terminated and he was immediately re-employed under the new terms and conditions. He brought a claim for unfair dismissal.

What did the tribunal and the Commissioners decide?

The tribunal found in favour of Mr Clayton and his colleagues and set another date to decide on what to award them. However, in the interim, the council and the employees reached an agreement that their right to the allowance would be reinstated and that they would also receive a basic award to compensate them. The tribunal drew up a consent order to that effect.

Mr Clayton was duly awarded £5,060, but he then faced a problem with the Inland Revenue who said he had to pay tax on it. He appealed against that decision to the General Commissioners who agreed with him. They said that the payment was not chargeable to tax under section 19 of the Income and Corporation Taxes Act 1988 as an emolument (a profit on earnings) or under section 154 as a benefit in kind.

Instead, the Commissioners decided that it fell within section 148 as a payment received 'in connection with the termination' of his employment. Since the payment was less than the £30,000 threshold set by the legislation, it was not taxable.

What did the Inland Revenue argue?

The Inland Revenue appealed to the High Court. It argued that the tribunal had no jurisdiction to order the payment of a basic award, and that the order for reinstatement meant that Mr Clayton had to be treated as though he had not been dismissed. The payment he received referred to his past and continuing employment, and as a result it was either an emolument or a benefit in kind.

What did the High Court say?

The High Court disagreed. It said that the payment was not taxable under section 19 as an emolument because that applies to something paid as a reward for past services or as an inducement to perform services in the future. This payment resulted simply from the negotiated settlement of a dispute between the parties.

Although everyone agreed that the tribunal would not have had the power to order the payment as well as reinstatement at a contested hearing, the court did not accept that rendered the payment taxable as an emolument.

The fact that the tribunal had no jurisdiction to order the payment did not alter the fact that it had been agreed between the employer and Mr Clayton.

And nor was it taxable as a benefit in kind under section 154, which requires the benefit to be provided for a reason connected to Mr Clayton's employment. This payment resulted from the contract between the parties to settle a dispute and not because they were employer and employee.

The General Commissioners were therefore correct to decide that the payment fell within section 148.