The concept of damages applies to any contract, including an
employment contract. Whenever one party to a contract acts contrary
to its terms (that is, breaches the contract), and by doing so
inflicts a loss on the other party, the latter can sue for damages.
So rules that apply to calculating damages in general law also
apply where an employer breaches an employment contract. Probably
the most common breach in this context is where an employer fails
to give proper notice of termination.
A payment of damages falls within Section 401 ITEPA 2003 (see EIM13005). Whether a payment is damages can be a difficult issue and close attention to facts is essential (see EIM12977 and subsequent guidance).
When an Employment Tribunal, a Court or parties to a termination settlement calculate damages they will usually follow the “Gourley principle”. This principle is a rule of non-tax law that derives from British Transport Commission v Gourley (1955). There is an example at EIM13995.
The principle is that a person must not be placed in a better or worse position than if the contract had actually been carried out. For example, say an employer fails to give proper notice of termination to an employee, and there is no contractual provision or practice relating to payments in lieu of notice (see EIM12976 onwards). A payment for the breach is one of damages (see EIM12978).
The sum of damages is first calculated by reference to the pay and benefits that the employee would have received during the notice period if proper notice had been given, for example gross pay of £2,000. Note that this is not in fact pay but is merely part of the calculation of the appropriate level of damages.
But £2,000 would place the employee in a better position than if the contract had been carried out because if the employee had received pay during notice, it would have been taxed and liable to NICs, leaving (say) £1,500 in hand. As the damages payment itself is not taxable as it is within the £30,000 threshold (see EIM13500) and not liable to NICs the employee would keep the whole £2,000. So to satisfy the Gourley principle, the damages payment is adjusted to £1,500.
It is important to recognise that this £500 adjustment to the sum of damages is not adeduction of tax and must not be dealt with as such. The actual payment made to the employee (£1,500 above) must be considered under the normal taxation rules for that termination payment (in this case, EIM12978).
What is actually paid is taxed, under the appropriate tax law. If the parties make mistakes in this process that leave a party out of pocket, that is a matter for the parties to remedy between themselves.
Another aspect is that anyone suffering loss as a result of a breach of contract is expected to mitigate the loss. This means that a dismissed employee must seek suitable alternative employment or can be treated as doing so. An employer is entitled to reduce damages accordingly. So the amount of damages can be reduced to take into account earnings in a new employment during what would have been the notice period. It can also be reduced to take into account what could have been earned if the employee had not failed to seek alternative suitable employment.
Note also that these adjustments and calculations represent an ideal. In practice, negotiations may have regard only to some of them, or even ignore them. It is important to remember that if that happens, it does not necessarily mean that the payment is not damages. It may only mean that the employee has in strictness been overcompensated or undercompensated according to law. However, if a payment reflects none of the adjustments associated with a damages payment in general law (see EIM13070) then it is open to question whether it is in fact a payment of damages. Whether it is depends on the facts of the case (see EIM12977).