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Is my compensation taxable? It depends…

10 July 2019

 

A client recently asked us if damages received from an accountant who has given negligent tax advice (not us, obviously!) are taxable.  The answer is: almost never.  But it got us thinking about the taxation of damages generally: what follows is a five-minute primer.

As with all receipts, you start by considering whether there’s a charge to Income Tax.  Case law has established a “filling a hole” principle: if what you receive replaces something that would have been subject to Income Tax (or taken into account in charging Income Tax), the compensation is treated in the same way.  So, for example, compensation for loss of profit, or for loss of rental income, is treated in the same way as the profit or income lost.

There’s a subtle point though.  Sometimes damages for complete loss of a capital asset are computed by reference to the trading profit that would have been generated by the asset: that doesn’t make the damages taxable as trading income.  As the courts have said: “The method by which the compensation is assessed in the particular case does not identify what it was paid for; it is no more than a factor which may assist in the solution of the problem of identification.”

More arcanely, you might even be trading in compensation claims: that is, taking assignments of the claims of others, pursuing them to completion and hoping to turn a profit.  Such a profit is likely to be subject to Income Tax.

Compensation received in connection with an office or employment has its own special rules which warrant their own briefing, so we won’t cover them here.

Having ruled out a charge to Income Tax, consider Capital Gains Tax (“CGT”).

By statute, compensation for “any wrong or injury suffered by an individual in his person or his profession or vocation” is exempt from CGT.  “In his person” is to be read in distinction to “in his finances”: the exemption applies to compensation for personal injury, distress, embarrassment, loss of reputation, unlawful discrimination, defamation, etc.  “Profession or vocation” is by concession extended to trades and employments.  And “his” obviously includes all genders.

As regards other compensation, a court ruling a few years ago put the cat among the pigeons by holding that the right to take court action for compensation is itself an asset for CGT purposes, so that any recovery is (subject to the exemption referred to above) liable to CGT.  Happily, that was effectively reversed by extra-statutory concession (ESC D33).  This provides that to the extent that the compensation relates to a form of property that is itself an asset for CGT purposes, it may be treated as deriving from the underlying asset (and therefore as being a part-disposal of it, allowing the deduction of an appropriate part of the cost of the asset) rather than from the “right to take action” (which typically has no CGT “base cost”).

That leaves compensation that does not relate to any underlying asset.  The classic example is where damages are claimed for incorrect financial or tax advice.  Until January 2014 such compensation was (by ESC D33) tax-free without limit.  From January 2014 only the first £500,000 is tax-free: beyond that a claim to exemption must be made and HMRC will review the position on a case-by-case basis.  However, HMRC confirm that a claim will be accepted if three conditions are all met, namely:

  • the right of action was acquired in connection with goods or services that the payer has provided as part of their trade, profession or vocation (in particular this condition is treated as met where the right of action relates to mis-selling of a financial product and the person who provides that financial product is regulated by the Financial Conduct Authority)
  • the payee did not acquire the right of action by transfer from a spouse or civil partner
  • the payee did not acquire the right of action from another person for consideration

All of which means that the answer to the original question (are damages received from an accountant who has given negligent tax advice taxable?) is, in almost all cases, no.

For more information, please get in touch with your usual BKL contact or use our enquiry form.