Horizon. Windrush. Infected blood. What do all these scandals have in common?
Compensation: and, furthermore, a specific exemption from tax for that compensation (under Finance Act 2020, Schedule 15).
Which got us thinking about the tax treatment of compensation more generally.
So: you’ve suffered some wrong: you’re compensated. Do you need to worry about tax?
It depends.
If the compensation relates to a loss of business receipts, the compensation is likely to be taxable. It’s sometimes called the ‘filling a hole’ principle. So (for example) your shop is forced to close because next door’s builder accidentally cuts off your power, and you’re compensated for loss of profit: taxable. Likewise, any reimbursement of a tax-deductible business expense will be taxable.
It’s not quite that simple though. The fact that a claim is quantified by reference to loss of income doesn’t necessarily make the receipt taxable. The most common example is a claim for personal injury – this will very often include an element for loss of earnings, but no part of the receipt is taxable. Or the compensation for the destruction of a capital asset may sometimes be computed by reference to the income it would have generated: that doesn’t convert the compensation from a capital receipt into income.
If a receipt isn’t subject to Income Tax, it will be necessary to think about Capital Gains Tax (‘CGT’). Some receipts are specifically exempted, such as compensation or damages for any wrong suffered by a person ‘in his person or in his profession or vocation [extended by concession to trades and employments]’. ‘In his person’ includes not only physical injury but also compensation for distress, embarrassment, loss of reputation or dignity, unfair or unlawful discrimination and so on.
Where compensation relates to something which is an asset for CGT purposes, it’s likely to be treated as a disposal or (if the asset isn’t lost or wholly destroyed) a ‘part-disposal’ of the asset. One exception is where all (or pretty much all) of the compensation is spent fixing the damage: another is where the compensation is ‘small’ in relation to the value of the asset.
That leaves the case where the compensation is of a capital character, isn’t specifically exempt by statute but doesn’t involve any form of property which is an asset for CGT purposes. The classic example is where a professional adviser has given misleading advice, for example in regard to tax or some other financial matter. In that case the compensation is treated as tax-free up to a limit of £500,000. If the amount exceeds £500,000 it is possible in most circumstances to make a claim to HMRC that the excess should also be tax-free.
For more information on tax and compensation, please get in touch with your usual BKL contact or use our enquiry form.