Is tax payable on compensation? Emma Slade, a specialist professional negligence solicitor, considers this crucial question in relation to CGT
“In this world nothing can be said to be certain, except death and taxes.”
Sadly, Franklin had the right of it and as much as we try to avoid it, both are inevitable. There are so many different forms of tax but this article is limited to a brief consideration of the effect of Capital Gains Tax (CGT) on damages and compensation received as a result of a civil claim.
Let us start from the beginning: what is CGT? In many respects, it is an extra form of Income Tax. Just as you pay income tax on your earnings, so you pay CGT on any gains or profit that you may make on the disposal of an asset. Probably the simplest example is if you buy a property for £100,000 to rent out and a few years later sell it for £150,000, you will have to pay tax on that £50,000 gain.
You also have to apply that concept to compensation. Is compensation income? Or is it an asset where there has been a gain? Do you pay income tax or Capital Gains Tax?
It all comes down to whether or not the compensation arose from an asset or not. There was a bit of a hiccup in 1985 in the Zim Properties Ltd -v- Proctor case where the court was asked to determine whether the right to sue was an asset for CGT purposes. Alarmingly, it concluded that it was. The court took the view that damages are awarded in exchange for compensation, so the right to sue was a valuable asset upon which CGT should be charged.
This brought with it inordinate problems. If in a professional negligence scenario, for example, your surveyor overvalues your house, a civil claim for compensation is supposed to put you back into the position as if the professional negligence had not occurred. However, under the Zim principles the Claimant would have to pay tax on that sum. It didn’t seem fair, so fortunately, HMRC introduced ESC D33 which in effect overruled Zim. It stated that only where there is an actual underlying asset, would CGT apply. If there is no underlying asset, no CGT would be payable.
This position was changed in 2014. With effect from 27th January 2014, compensation that did not have an underlying asset would be exempt from CGT, but only for the first £500,000. For amounts of compensation above this amount to be exempt, a request has to be made in writing to HMRC.
However, before the panic buttons get hit, there are many exceptions to this rule, of which the following are but a few:
- Damages for physical injury, distress, embarrassment, loss of reputation or dignity, unfair or unlawful discrimination and for libel or slander are all exempt;
- Loss of earnings are exempt, but the damages are reduced by the amount of tax that would have been payable had the Claimant been employed;
- Any damages awarded to an individual by reason of his trade or employment are also exempt. In other words, if you bring a claim in the Employment Tribunal or settle an employment claim via a Compromise Agreement, then the compensation aspect will be tax free; and
- Compensation for professional negligence claims in relation to an action in respect of a wrong or an injury is exempt.
There are two important payments though that are not exempt: taxable receipts and gains on underlying assets.
The issue of taxable receipts was considered in the case of Deeny -v- Gooda Walker. This case arose out the Lloyd’s Names cases where the courts were asked to consider whether the damages arose out of the negligent advice given by the underwriters (professional negligence – ergo tax exempt) or whether it would be considered loss of profits. One of the arguments used was based on the judgment in London and Thames Haven Oil Wharves Ltd -v- Attwooll:
“Where, pursuant to a legal right, a trader receives from another person compensation for the trader’s failure to receive a sum of money which, if it had been received, would have been credited to the amount of profits (if any) arising in any year from the trade carried on by him at the time when the compensation is so received, the compensation is to be treated for income tax purposes in the same way as that sum of money would have been treated if it had been received, instead of the compensation.” [my emphasis]
In short, if you are claiming loss of profits, that part of your damages claim is going to be subject to Income Tax and so rather than receiving the damages net of tax like you do with loss of earnings (see 2 above), the compensation will have to be “grossed up”, ie paid in full so you can discharge your own tax liability. It is known as the ‘reverse-Gourley principle’.
In addition, if there is an underlying asset to your claim whose disposal or deemed disposal gives rise to the damages payment, the compensation is chargeable for CGT purposes. The only example I can find to illustrate this is that suggested by John Walters in his paper Taxation of Damages, Costs and Interest:
“For example, a property in the case of an action against an estate agent for negligent advice on sale – the compensation can be treated as proceeds on a disposal, or more likely a part disposal, of the underlying asset – i.e. the property, with the allocation of base cost and availability of reliefs and exemptions appropriate to such a disposal or part disposal.”
Personally, I do not agree that is a good example as I would suggest that “negligent advice” falls under the professional negligence exemption. A better example might be where you are suing for, say, a loss of bargain on the purchase of an investment property. If you buy an investment property for £150,000 and sell it the following day for £200,000, you would be paying CGT on that £50,000 gain. It seems logical therefore that if you are suing a professional for their failure to expedite that purchase and the purchase fell through, you could expect to include in the claim, the loss of that £50,000 gain. If that is the case, I would fully expect the HMRC to be asking for its portion of that profit in which case, any settlement made with the Defendant should be grossed up to include that liability.
As I said at the beginning of this article, this is only a very brief consideration of the question, ‘is tax payable on compensation?’ – the edited highlights really – for like all tax matters, it is never straightforward and almost always fact dependent. Even in the Deeny case, there was dissent among the Law Lords about what constituted an income receipt as opposed to a capital receipt. In any event, I would strongly recommend that if there is any doubt, speak to a tax adviser.
We are specialist professional negligence solicitors, representing claimants nationwide in cases of professional negligence against solicitors, accountants, surveyors and other professionals. We offer a free case assessment service. Simply submit brief details by email to [email protected] or call us on 0808 139 1606.