US UK Tax Returns Preparation: UK Discrimination Awards

A UK employment tribunal award or settlement agreement that HMRC never taxes can still be fully taxable on a US return. For American citizens and green card holders in London, US UK tax returns preparation must treat injury to feelings and discrimination damages as ordinary income, because Section 104(a)(2) excludes only physical injury — and with no UK tax deducted, there is no foreign tax credit to relieve the charge.

Why an award the UK leaves untaxed can produce a real US tax bill

This is one of the sharpest and least understood asymmetries in the whole US-UK system, and it lands almost exclusively on senior people: the managing director who settles a sex or race discrimination claim against a bank, the executive who signs a settlement agreement on the way out of a hedge fund, the partner who brings a disability claim and resolves it at mediation before a hearing.

On the UK side, an award or settlement sum that genuinely compensates discrimination not arising from the termination of the employment is commonly outside the employment income charge altogether. It is not earnings, it is not a termination payment, and so nothing is deducted through PAYE. The claimant receives the money gross, the solicitor confirms no UK tax is due on that element, and everybody moves on.

On the US side, the analysis begins from an entirely different premise. A US citizen is taxed on income from whatever source derived, wherever in the world they live and wherever the payer sits. The only relevant escape route is the statutory exclusion for damages received on account of personal physical injury or physical sickness. Damages for emotional distress, humiliation, hurt feelings and reputational harm sit outside that exclusion unless they are attributable to a physical injury. "Injury to feelings", the UK's own term of art, is almost the precise formulation that the US exclusion was amended to exclude.

The result is a genuine one-sided charge. The UK does not tax it. The US does. And because the foreign tax credit relieves only foreign tax paid or accrued, an award on which no UK tax was ever paid generates no credit at all. There is nothing to offset. At Jungle Tax this is one of the most common reasons a high-earning American in the City discovers a five- or six-figure US liability on money their UK adviser correctly told them was tax-free.

How the UK actually taxes a tribunal award or settlement agreement

You cannot prepare the US return until you understand what the UK treated each line as. UK practice splits a settlement into broadly four buckets, and the split drives everything downstream.

Earnings under the general employment income charge

Anything that is in substance remuneration for services already performed remains earnings. Unpaid salary, accrued holiday pay, a contractual or discretionary bonus that had crystallised, deferred cash awards, vested or vesting share awards, and equal pay arrears all fall here. These are taxed in full through PAYE with National Insurance, and — importantly for our purposes — they generate UK tax, so they usually do carry a credit position for US purposes.

Termination payments

Compensation for the loss of the office or employment itself is taxed under the specific termination provisions, with a long-standing exempt slice available before the balance is charged. That exempt amount has been fixed for many years and any figure should be confirmed against current HMRC guidance before it is relied on in a computation. Post-employment notice pay is carved out and taxed as earnings regardless.

Injury to feelings and statutory discrimination compensation

This is the bucket that creates the cross-border trap. HMRC's position, set out in its Employment Income Manual at EIM12965, distinguishes between injury to feelings attributable to discrimination that occurred before and independently of the termination, and injury to feelings arising from the termination itself. The former can fall outside the employment income charge entirely; the latter is generally drawn into the termination charge. Quantum is expected to be proportionate to the published tribunal bands for injury to feelings, and HMRC will challenge an apportionment that bears no relationship to how the pleaded claim was actually structured.

Compensation for genuine injury

Where a recognised psychiatric or physical medical condition is established, a separate and more generous UK treatment can apply. This category matters enormously on the US side too, for entirely different reasons, and is examined below.

US versus UK: how each component is treated

Settlement component	Typical UK treatment	Typical US treatment	Foreign tax credit available?
Unpaid salary, holiday pay, accrued bonus	Earnings; PAYE and NIC	Wages; ordinary income	Yes — UK tax paid
Equal pay or historic underpayment arrears	Earnings; fully taxable	Ordinary income	Yes
Compensation for loss of office	Termination charge; exempt slice then taxable	Ordinary income in full	Partially — only on the taxed portion
Post-employment notice pay / PILON	Earnings; taxed in full	Wages; ordinary income	Yes
Injury to feelings — pre-termination discrimination	Commonly outside the charge; paid gross	Ordinary income; no exclusion	No — nothing to credit
Injury to feelings — arising from termination	Within the termination charge	Ordinary income; no exclusion	Partially
Damages for physical injury or physical sickness	Generally not taxable	Excluded under Section 104(a)(2)	Not needed — excluded both sides
Interest on the award	Often paid gross; savings income	Interest income; potentially investment income	Usually no
Legal costs paid direct to the solicitor	Can be paid without deduction if properly structured	Frequently gross income to the claimant	No
Restrictive covenant payment	Taxed as earnings	Ordinary income	Yes
Employer pension contribution	Often outside the charge	Requires separate analysis; not automatically excluded	Usually no

What is the origin-of-the-claim test, and why does it decide everything?

US law does not ask what the settlement agreement calls a payment. It asks what the payment was in lieu of. The published IRS guidance on the tax implications of settlements and judgments frames the question directly: what was the settlement intended to replace? If the money stands in the place of wages, it is taxed as wages. If it stands in the place of a bonus, it is a bonus. If it stands in the place of damages for a physical injury, it is excluded.

Two consequences follow, and they pull in opposite directions.

• Labels do not control, but they are powerful evidence. Where the parties expressly and credibly allocate the consideration across the pleaded causes of action, that allocation is generally respected — provided it is consistent with the claim as actually advanced and with what a tribunal might have awarded.
• An allocation that is invented for tax reasons will not survive. An agreement that assigns the bulk of a seven-figure sum to injury to feelings when the pleaded claim was overwhelmingly about lost remuneration is vulnerable on both sides of the Atlantic. HMRC tests it against the tribunal bands; the IRS tests it against the origin of the claim.

Why does "injury to feelings" not qualify for the Section 104(a)(2) exclusion?

The exclusion reaches damages received on account of personal physical injuries or physical sickness. The word "physical" was inserted by statute precisely to remove non-physical harms from its scope. Emotional distress is excludable only to the extent it is attributable to an underlying physical injury or physical sickness — or, in a narrow carve-out, to the extent of amounts paid for medical care attributable to that emotional distress.

UK "injury to feelings" is, by construction, compensation for distress, humiliation and affront to dignity. It is not compensation for bodily harm. So in the ordinary case it is fully includible in US gross income even though the UK regarded it as falling outside earnings entirely.

Does a psychiatric diagnosis change the US answer?

Sometimes, but the bar is higher than most claimants assume. A diagnosed psychiatric condition is not automatically a "physical injury or physical sickness" for US purposes, and physical manifestations of distress — insomnia, headaches, stomach upset — have historically been treated as symptoms of emotional distress rather than as physical injury. Where there is a genuine physical injury or physical sickness, the medical evidence needs to exist contemporaneously, the claim needs to have been pleaded on that basis, and the settlement needs to allocate to it explicitly. This is a documentation exercise that has to happen before signature, not during US tax return preparation eighteen months later.

Component-by-component: preparing the US return

The part attributable to loss of office

Compensation for the termination itself is ordinary income for US purposes in full. There is no US analogue to the UK exempt slice. Where the UK applied its exemption, the American ends up taxed by the US on an amount the UK deliberately relieved — and again with no credit for the relieved portion. This is the second half of the same structural problem.

The interest element

Tribunal awards frequently carry interest, and interest is almost never excludable. It is interest income even where the underlying damages are excluded. It may also be drawn into the US investment income charge, which is not a creditable-tax-friendly regime and for which treaty relief is contested. Interest must be identified and stripped out separately; it is commonly buried in a single lump sum figure and missed entirely.

Legal costs and the solicitor's fees

Where the respondent pays the claimant's legal costs, the US question is whether the claimant is treated as having received that amount and then paid it away. In employment discrimination cases there is a specific above-the-line deduction for attorney fees and court costs that can neutralise this, but it is claim-specific, it does not cover every cause of action, and its availability where the claim arises under UK law rather than a listed US statute requires careful analysis. The default assumption should be that costs are in scope until proven otherwise, and the amount and payment route must be documented.

Deferred cash, share awards and carried interest released under the agreement

Settlement agreements at this level routinely accelerate or preserve deferred awards. Each has its own US character, its own timing, and its own sourcing. These are the components most likely to carry real UK tax, and therefore the components most likely to generate the credits that partially shelter the rest. Getting the sourcing right on this element is often worth more than everything else in the file. This is core cross-border tax work.

Why the wording of the settlement agreement matters to the US return

By the time the return is being prepared, the agreement is signed and the money has moved. Almost nothing can be improved after that point. The drafting decisions that determine the US outcome are made in the fortnight before signature, usually by an employment solicitor who has no reason to be thinking about the IRS.

Where an American is settling, the agreement should ideally:

• Allocate expressly across each pleaded head of claim, with figures, rather than recording one undifferentiated "compensation" sum.
• Identify the period to which each element relates — pre-termination discrimination versus termination-related — because that drives both the HMRC charge and the US sourcing.
• Separate interest as its own line rather than folding it into damages.
• State the basis for any physical injury or physical sickness element and cross-refer to the medical evidence.
• Record the costs treatment: who pays whom, directly or by reimbursement.
• Specify the currency and payment date, which determine the US translation rate and the tax year of inclusion.
• Avoid tax indemnities drafted solely by reference to UK tax, which can leave the claimant bearing a US liability nobody modelled.

What if the agreement is silent?

A silent agreement does not make the payment tax-free; it removes the claimant's best evidence. Where there is no allocation, the analysis falls back to the payer's intent and the substance of the claim, reconstructed from the pleadings, the schedule of loss, the without-prejudice correspondence and the mediation position papers. That reconstruction is doable and is frequently the right answer, but it must be documented at the time of filing rather than assembled years later under examination. Preserve the ET1, the schedule of loss, the respondent's offer letters and the solicitor's completion statement.

The foreign tax credit problem, stated precisely

The credit mechanism described in the IRS guidance on the foreign tax credit, claimed on Form 1116, requires a foreign income tax that was paid or accrued and that represented a legal and actual liability. An award the UK deliberately left outside the charge satisfies none of that. There is no foreign tax, so there is no credit, however foreign the income plainly is.

Three further points usually surface in preparation:

• The earned income exclusion rarely helps. Damages for injury to feelings are not compensation for services performed, so they generally do not qualify as foreign earned income in the first place. Even where an element is properly characterised as wages, the exclusion claimed on Form 2555 is capped and a senior banker's ordinary salary will normally have absorbed it already.
• The tax years do not line up. The UK tax year ends in early April; the US year ends in December. An award paid in, say, February can sit in one UK year and a different US year from the salary it partly replaces, which distorts the credit calculation in the year of receipt and the year either side. Credits and income must be matched year by year, not netted across the settlement.
• Currency translation is not cosmetic. The sterling award is translated at the rate on the date of receipt. A large award and a volatile rate can shift the dollar figure materially, and the same movement can create a separate currency gain when the money is later converted or the mortgage repaid.

For claimants who also hold UK pensions, ISAs or investment accounts, the same structural mismatch appears elsewhere in the return, and our UK tax services and US tax services teams work the two computations together rather than sequentially.

What if the award landed in a year you never filed?

This is the situation we see most often, and it is more recoverable than it looks. A great many Americans in the City discover their US filing obligation only when a bank, a fund administrator or a mortgage lender asks for a US return — and by then a substantial tribunal award may be sitting several years back in an unfiled period.

The sequence we work through:

• Fix the year of inclusion. Identify the date the money was constructively received, not the date of the agreement or the date of the tribunal judgment. Money held in a solicitor's client account pending completion is a common complication.
• Reconstruct the allocation from the contemporaneous documents, as above, and compute the taxable and excluded components in dollars.
• Test the information return position. The account that received a large settlement is very often the account that pushed the claimant over the FBAR reporting threshold for the first time, and potentially over the specified foreign financial asset thresholds too. A single large receipt into an otherwise modest UK current account can create reporting obligations in a year the claimant never considered.
• Assess the route back. Where the failure to file was non-wilful, the IRS streamlined filing procedures — specifically the Foreign Offshore Procedures for those resident outside the United States — remain the principal mechanism, requiring amended or delinquent returns for a defined recent period, foreign account reports for a longer defined period, and a signed non-wilful certification. The IRS sets out the framework in its published streamlined filing compliance procedures; the number of years and the certification requirements should be confirmed against the current version before a submission is built.
• Draft the certification narrative carefully. A settlement award that was correctly untaxed in the UK is a coherent and credible explanation for a good-faith misunderstanding. It is exactly the kind of fact pattern the non-wilful standard contemplates — but only if the narrative is written properly and the underlying computations support it.

Errors we see most often on these files

• Treating the whole award as exempt because the UK solicitor said it was tax-free. The UK letter is correct; it simply answers a different question.
• Reporting the net figure after the solicitor's costs, rather than the gross with a separate deduction analysis.
• Missing the interest element inside a single lump sum.
• Claiming a foreign tax credit by reference to the total PAYE suffered in the year, which cross-subsidises the untaxed award with credits attributable to salary and fails the matching requirement.
• Using the year-end or annual average exchange rate for a single large receipt instead of the rate on the date of receipt.
• Overlooking the information return consequences of the receipt itself.
• Assuming a UK tax indemnity in the agreement covers a US liability. It almost never does.

Preparing the return: what we need from you

• The signed settlement agreement or the tribunal judgment, in full.
• The ET1 and the schedule of loss, which evidence the origin of the claim.
• The solicitor's completion statement showing gross sums, deductions and the payment route for costs.
• Payslips and the P45 or P60 for the year, to isolate what actually went through PAYE.
• Bank statements showing the date and amount of receipt in sterling.
• Any medical evidence relied on in the claim.
• Details of every UK account, pension and investment held during the year, for the information return analysis.

Further reading across our cross-border guides covers the adjacent issues these files usually raise — unreported UK pensions, ISAs and investment accounts, and the mechanics of catching up on missed years.

Speak to us before you sign, not after

If you are a US citizen or green card holder negotiating an employment tribunal claim or a settlement agreement in the UK, the US cost of the deal is set by how the agreement is drafted — and there is a short window in which that can still be influenced. If the award is already behind you, and particularly if it fell in a year you never filed, the position is still very fixable, but it needs to be computed and documented properly rather than estimated. To review your settlement, model the US charge and put the filings right, contact our cross-border team for a confidential consultation. Every engagement is handled discreetly by senior cross-border preparers who deal with awards of this size routinely.