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A client has been ill for some years with myalgic encephalomyelitis (ME) and has not been able to work. There is no immediate end in sight to the illness. The client's employers have a permanent health insurance contract which is continuing to pay my client the salary which was being earned prior to the illness commencing. It is taxed in the normal way through PAYE.
The insurance company has now offered my client's employers a lump sum in full and final settlement of all amounts payable under the contract. The employers would, of course, pass this lump sum on to my client.
A client has been ill for some years with myalgic encephalomyelitis (ME) and has not been able to work. There is no immediate end in sight to the illness. The client's employers have a permanent health insurance contract which is continuing to pay my client the salary which was being earned prior to the illness commencing. It is taxed in the normal way through PAYE.
The insurance company has now offered my client's employers a lump sum in full and final settlement of all amounts payable under the contract. The employers would, of course, pass this lump sum on to my client.
How would such a lump sum be taxable, if at all?
Query T16,659 — PHI.
Reply by N.K.:
Looking at HMRC's booklet IR153, Tax exemption for sickness or unemployment insurance payments, pages 6 and 7 deal with 'Employers' schemes'. PHI does not mention that the client made any contributions to the permanent health insurance premiums paid and so, from what is explained in paragraphs 19 and 20, the current receipts from the insurance company are fully taxable which, as will be seen later, also has a bearing on the proposed lump sum's tax status. It should be remembered that it was the employer who received the tax relief on the payment of premiums.
In HMRC's Assessment Procedures Manual, paragraphs AP1032 to 1044 in the section entitled 'Sickness, Disability and Unemployment Benefits under Insurance Polices and Friendly Society Contracts' cover the subject.
We have been told that, currently, the permanent health insurance contract payments are subject to PAYE and this is confirmed under AP1033, 'Sickness and disability benefits liable to tax under Schedule E' as follows.
'Some employers have schemes for making payments to employees who are absent from work due to prolonged sickness or disability. The liability under such schemes is often insured under a group insurance policy. The payments made by the employer to the employee under such a scheme are taxable under the rules of Schedule E ...'
Paragraph 10 of HMRC's guidance on tax exemption for sickness or unemployment insurance payments (on the Internet at www.hmrc.gov.uk/individuals/taxexemption.htm) is headed 'My insurer has offered me a lump sum to give up the rights to future benefits. Is this tax free?' and answers the query raised:
'There is no tax to pay on this sort of lump sum unless … benefits are paid under an employer's ... scheme and you did not pay the premiums, or pay tax on the premiums, that relate to your benefits ...'
AP1040, 'Lump sum sickness or disability benefits' expands on the subject.
'A lump sum is not chargeable to income tax unless it is made up of accumulated benefits that are ... chargeable under Schedule E (see AP1033). Most lump sums will not be chargeable.
'An insurer may make an offer of a lump sum in commutation of all future rights the policyholder has under the policy. In such a case the lump sum is a capital sum and is not chargeable to income tax or capital gains tax. The only exception is where the benefits constitute a pension ...'
There might be an advantage in consulting the insurance company on this subject.
Reply by Thicket:
The taxation of personal health insurance premiums and receipts can be confusing and little formal guidance seems to be available. However, it should be possible to analyse the tax consequences by carefully dissecting the arrangement.
The most usual situation is for the employer to arrange a group policy for all employees (or at least those chosen to receive this benefit). The employees are not named in the policy. The insurance company is prepared to accept the risk on an actuarial basis of a spread of ages. In this case, there is no personal benefit for the employees to declare. The employer obtains a tax deduction for the annual premium. If an employee falls long term sick and a benefit is payable, this is payable to the employer, being the policyholder. The receipt allows the employer to continue to pay the sick employee's salary (or at least a reduced salary according to the policy on such matters). The insurance money is a taxable receipt of the employer, but is matched by an allowable deduction for the salary costs paid to the employee.
The employee who is on sick leave is in receipt of salary from the employer which continues to be taxed under PAYE and suffer Class 1 NICs, and this is confirmed in the present case.
PHI now considers the situation where the insurance company is offering a lump sum in commutation of all further amounts due. This would again be taxable in the hands of the employer just as the ongoing insurance receipts would be. If the employer chose to pass this on to the employee, then a tax deduction would be in order.
PHI is concerned as to how his client, the employee, would be taxed. The default position would be that this would be taxed as income from employment, and subject to PAYE and Class 1 NIC. However, this may be improved upon if the lump sum comes within the scope of ITEPA 2003, Pt 6 Ch 3 which deals with payments on termination of employment. The first £30,000 of such a payment may be free of income tax. It should be possible to construct a compromise agreement so that the employment is terminated in return for the client accepting a lump sum. We are not told the exact amount involved. It may be that the employer may make a part of the payment into the client's pension scheme, which would be tax free. Details of the employee's age, future earning prospects, etc. will need to be taken into account.
ITEPA 2003, s 406 deals with the exception for payments made on termination due to injury or disability; such payments may be exempt from taxation. However, following the case of Hasted v Horner [1995] STC 766, HMRC may take a strict view as to whether the payment is made on account of the disability or illness and nothing else.
If there are doubts over whether the payment will fall in to the £30,000 exemption, certainty can be obtained by submitting the proposal to the local district office of HMRC for advance clearance. Experience shows that this can be a very quick and effective method of removing doubts. If it is likely that the client will have a low income for a period of time at least, it may be effective to arrange for the lump sum to be paid near the start of the tax year, in order to access a full year of allowances and lower rate tax band. Again, if payment is made after employment is terminated, only basic rate tax need be deducted by the employer. Any higher rate liability is collected by submission of the self-assessment tax return and payment is due by 31 January following the end of the tax year, which may be a significant cash flow advantage.
Extract from reply by Weatherman:
Whereas some people in the past have disputed the existence of ME as a medical condition, a report in The Times (see 21 July 2005) coincidentally caught my eye recently. This indicates that: 'British scientists … have discovered the first firm evidence that the illness — also known as chronic fatigue syndrome (CFS) — leads to clear biological changes in the blood, offering the strongest indication yet that its trigger is physical. The findings, from a team at Imperial College, London, promise to lead to the first reliable blood test for the condition …'. The article mentions that 'the results support a theory that the condition is often triggered by viruses … which cause lasting changes in gene expression that lead to chronic fatigue. CFS often begins with a flu-like illness which never goes away'.
The reason for mentioning this is that the first impression is that a lump sum would be taxable on the basis that it replaces taxable income. However, one wonders if the payment could instead fall within the exemption from tax under ITEPA 2003, s 406(b), which states that 'this chapter ['payments and benefits on termination of employment'] … does not apply to a payment or other benefit provided … on account of injury to, or disability of, an employee'.
Information is provided in HMRC's Employment Income Manual at EIM13610 et seq which states that:
'disability means an incapacity to fulfil the duties of an office or employment caused either:
- by a sudden affliction (such as a heart attack); or
- by the culmination of a process of deterioration of physical or mental health caused by a chronic illness (such as bronchitis);
but not by the normal processes of ageing'.
EIM13610 refers to Hasted v Horner 67 TC 439 where a 58-year old tax consultant retired from a firm of accountants with a severance payment of £90,000 claiming that the payment should be exempt as it was made on account of mental disability brought on by the pressure of campaigning against the Inland Revenue. The claim was rejected, but the case established that there must be both an identified medical condition that disables or prevents the employee from carrying out the duties of the employment and the payment must be made on account of that disability and on account of nothing else. In the light of the latest research, might it be that ME would now more clearly fall within this description?
Could the payment of a lump sum represent the disposal by the employee of a right to income, i.e. the disposal of a capital asset? The possible tax implications when an income source is apparently converted into a capital sum are always somewhat fraught and an approach to the insurance company for their experience here might yield further information. Might the insurance company suggest that the employer is removed from the equation and negotiations take place between the insurer and employee directly?
