The taxpayer faces paying £130million in benefits to people who refused to work for free.
A government back-to-work scheme withdrew benefits from people if they did not take up placements in shops and offices to improve their employability.
After legal flaws were discovered in the scheme, the government passed retrospective laws shore it up.
But the emergency laws have been torn up by the High Court because it could breach their human rights.
The legislation was drawn up by Work and Pensions Secretary Iain Duncan Smith after the government was taken to court by a woman who refused to take a role in Poundland.
The taxpayer now faces a £130million bill for benefits denied to thousands of claimants for refusing to work, after a judge today ruled the retrospective laws were ‘incompatible’ with the European Convention on Human Rights.
The legal battle was sparked by University graduate Cait Reilly, 24, from Birmingham, who challenged having to work for free at a local Poundland discount store.
Last year the government lost in a Supreme Court bid to overturn an earlier ruling that regulations underpinning the schemes were invalid.
New laws were then passed to overcome flaws identified by three appeal judges in the Poundland case and to block any attempt to claw back lost benefits.
Mrs Justice Lang, sitting at the High Court in London, ruled the retrospective legislation interfered with the ‘right to a fair trial’ under Article 6 (1) of the convention.
Welfare minister Lord Freud’s warned repaying benefits withheld unlawfully would be ‘an undeserved windfall’ for claimants – a claim rejected by the judge.
Human rights lawyers said the judgement was a ‘damning assessment’ and, if upheld on appeal, could lead to some £130 million having to be paid out to thousands of jobseeker’s allowance claimants denied benefits under the schemes.
Phil Shiner, of Public Interest Lawyers (PIL), said: ‘This case is another massive blow to this Government’s flawed and tawdry attempts to make poor people on benefits work for companies, who already make massive profits, for free.
‘Last year the Supreme Court told Iain Duncan Smith and the coalition Government that the scheme was unlawful.
‘In this case the High Court has now told the Government that the attempt to introduce retrospective legislation, after the DWP had lost in the Court of Appeal, is unlawful and a breach of the Human Rights Act and is a further disgraceful example of how far this Government is prepared to go to flout our constitution and the rule of law.
‘I call on the DWP to ensure that the £130 million of benefits unlawfully withheld from the poorest section of our society is now repaid.’
The legal battle was triggered by a scheme where jobseekers were told to work for free in Poundland store to gain work experience
A DWP spokesman said the Government would appeal. He said: ‘We’re pleased the court recognised that if claimants do not play by the rules and meet their conditions to do all they can to look for work and get a job, we can stop their benefits. That is only right.
‘However, we disagree with the judgment on the legislation and are disappointed. It was discussed, voted on and passed by Parliament.
‘While this applies to only a minority of past cases and does not affect the day to day business of our Jobcentres, we think this is an important point and will appeal.’
The new legislation found incompatible with human rights laws is the Jobseekers (Back to Work Schemes) Act 2013.
But it remains in force and benefits will not be repaid pending an appeal.
The DWP spokesman said: ‘The 2013 Act remains in force. There is no change to the operation of our schemes from the outcome of the High Court today.
‘We will continue to help people back in to work and we will not be repaying any sanctions pending our appeal.’
In her ruling, Mrs Justice Lang said jobseekers Ms Reilly and Daniel Hewstone were both in receipt of jobseekers allowance – ‘a subsistence level benefit payable to persons actively seeking employment’.
At the time of their claiming, it was £56.80 a week for those aged 16-24 and £71.70 for those aged 25 and over.
Under the Jobseekers Allowance (Employment, Skills and Enterprise Scheme) Regulations 2011 claimants were required to take part in a variety of unpaid ‘work for your benefit’ schemes.
The retrospective creation of criminal offences and imposition of heavier penalties was prohibited under both international and domestic law, said the judge.
But human rights laws recognised that retrospective legislation ‘outside the criminal sphere’ might be justified in the public interest.
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