Out-Law Guide 2 min. read
11 Oct 2022, 1:43 pm
The tax treatment of damages should be considered at an early stage as this may need to be factored into the amount claimed.
Tax also needs to be considered in settlement negotiations to ensure the offer is enough.
The first issue affecting the tax treatment is whether the damages are 'income' or 'capital' in nature for the recipient.
The distinction between income and capital is complex. However, the general rule is that if the damages are to compensate for a loss of income or to make good a trading expense, then the damages are themselves of an income nature, and are therefore taxed as income. However, where the compensation for loss of income relates to the whole structure of the recipient’s trade - i.e. the complete loss of income-producing opportunity - it is capital.
Where the payment relates to a capital asset (such as a property or shares), it will usually be capital in nature.
If the damages are income in nature they will only be taxable if they fall within one of the categories of taxable income such as receipts of a trade or profession, receipts from a property business, savings income or employment income. There are also some exemptions which are more relevant to individuals, such as personal injury damages.
An example of a trading receipt would be damages to compensate for breach of contract to supply goods or services. Damages from a loss of profits claim will usually also be trading receipts.
Where the damages are capital rather than income in nature the tax position is principally governed by an Extra Statutory Concession, D33. Where the damages relate to an underlying capital asset then the claimant is taxed as if it has sold part of the asset. However, where there is no underlying asset the damages are treated as arising from the right to sue, which has no base cost and can be tax exempt.
Whether the damages are 'income' or 'capital' in nature for the recipient affects the tax treatment
A good example of a claim with no underlying asset would be a professional indemnity claim for misleading tax or financial advice. In contrast, negligent advice on the sale of a property would relate to the underlying asset of the property.
The tax exemption where there is no underlying asset is limited to £500,000. Whilst relief can be granted for awards in excess of this £500,000 threshold, it must be claimed from HMRC and in the case of corporates is unlikely to succeed. The claim can only be made once the size of the payment is known, which may be too late to influence the quantification of the claim or negotiation of the settlement.
Two further issues are particularly relevant when considering the tax treatment of damages.
The first is the extent to which the tax treatment of the payment in the hands of the recipient will be taken into account in determining the amount of an award. The courts will usually take into account both the tax payable on the award and the tax that would have been payable but for the dispute. This is known as the 'Gourley principle' after the 1956 House of Lords case British Transport Commission v Gourley, which introduced the concept that has now widely been adopted.
Secondly, the VAT treatment of the payment should be considered at the outset. For more details, see our Out-Law Guide: VAT treatment of UK termination and compensation payments.
01 Dec 2023