The Commissioners for HMRC v Keith Murphy

For employment income purposes, “profit” in section 62(2)(b) of the Income Tax (Earnings and Pensions) Act 2003 does not mean a net gain after litigation expenses. The “from” test asks whether the payment is remuneration or a reward for the employee’s services. Once that test is satisfied, the whole benefit is taxable, subject only to deductions expressly permitted by the statutory scheme. Costs incurred to recover remuneration are not expenses incurred in performing employment duties and cannot be deducted on that basis. The form or payment mechanism of a settlement does not alter its substance. A separately identified payment of costs may be outside earnings, but litigation costs, success fees and insurance premiums paid from taxable compensation remain taxable.

Mr Murphy, a police officer, participated in group litigation against the Metropolitan Police Service concerning unpaid overtime and allowances. The claim settled for a principal settlement sum plus agreed legal costs. A success fee and insurance premium were paid from the principal settlement sum.

The First-tier Tribunal dismissed Mr Murphy’s appeal against discovery assessments, holding that the whole principal settlement sum was taxable employment income. The Upper Tribunal allowed his appeal, holding that the success fee and insurance premium should be deducted in calculating profit under section 62(2)(b) of the Income Tax (Earnings and Pensions) Act 2003: [2021] UKUT 152 (TCC). HMRC appealed on the meaning of “profit”, the relevance of litigation costs and the proper application of the statutory scheme.

1. Appeal allowed. The Upper Tribunal’s decision was set aside and the First-tier Tribunal’s decision restored. Ground 3 did not require determination.
2. The statutory question was whether the principal settlement sum was earnings from employment. Under section 62(2)(b) of the Income Tax (Earnings and Pensions) Act 2003, the payment had to be a reward or remuneration for services. It was insufficient that Mr Murphy received it only because he was an employee. The “from” test in Hochstrasser (Inspector of Taxes) v Mayes [1960] AC 376 was the governing approach.
3. The authorities on reimbursement of expenses did not establish a separate net-profit test. They concerned whether a payment was remuneration for services, or whether an expense was deductible under the statutory deduction provisions. “Profit” in section 62(2)(b) meant a material benefit, income or revenue. Once the payment was earnings from employment, the whole benefit was taxable, subject only to deductions expressly allowed by the Act.
4. Litigation costs incurred to recover remuneration were not expenses incurred in the performance of employment duties. Their necessity for obtaining the settlement did not make them deductible from the settlement sum. The distinction between taxable earnings and allowable deductions was fundamental to the statutory scheme.
5. Eagles (Inspector of Taxes) v Levy [1934] 19 TC 23 was effectively on all fours. A comprehensive settlement for unpaid remuneration remained taxable in full where costs were not included in the settlement sum. The direct payment of the success fee and insurance premium by the employer did not alter the character of the principal settlement sum.
6. The agreed costs were separately identified and were not remuneration for services. The success fee and insurance premium, however, were paid from the principal settlement sum, which represented sums claimed under the employment contracts. The whole of Mr Murphy’s share of that sum was therefore taxable and PAYE was properly deducted.

1. Court of Appeal (Civil Division). HMRC’s appeal was allowed. The Upper Tribunal’s decision was set aside and the First-tier Tribunal’s decision restored.
2. Upper Tribunal (Tax and Chancery Chamber). The appeal from the First-tier Tribunal was allowed and the decision was remade in favour of Mr Murphy: [2021] UKUT 152 (TCC).
3. First-tier Tribunal. Mr Murphy’s appeal against the discovery assessments was dismissed.