Our series focused on the settlement of disputes considers issues encountered by practitioners across a range of dispute resolution specialities. This article discusses the often overlooked tax implications when settling a claim, highlighting the need for both claimants and defendants to seek expert advice.
Whilst the parties’ focus in a civil case is often the underlying dispute, it is critical that consideration is given to what tax could be due if damages or compensation is received and for a paying party, if any tax relief could be available.
Claimants
Claimants will need to first consider whether the settlement payment is to be considered income or capital.
Income
Payments are likely to be income if they are income by nature and fall into one of the categories of taxable income. These include receipts of a trade or profession, receipts from rental income, interest on savings (over the taxpayer’s saving allowance) or employment income. For example, if the claim relates to a loss of profits, the compensation payment is likely to be treated as income. Further, late payment interest in respect of damages may be treated as income for tax purposes.
There are some exemptions, such as personal injury damages that need to be considered carefully: some compensation is tax free (for example damages received in relation to personal injury).
If the payment is treated as income, it is likely to be taxable. The recipient will need to consider whether any reliefs are available or if the income payment can be offset against any losses.
Capital
Payments that are capital in nature are governed by HMRC’s Extra Statutory Concession D33 (“ESC D33”). HMRC’s internal manual sets out that “where a right of action arises because an asset has been totally or partially lost, destroyed or damaged, we now consider that any capital sum received by way of compensation should be treated as having been derived from the asset itself rather than the right of action”. For example, where the cause of action relates to professional negligence on the sale of a property, the negligent advice is related to the property itself and therefore, the damages would relate to the property and be taxed as property income. It is important to note that ESC D33 introduced a threshold, in circumstances where there is no underlying ‘asset’ for capital gains tax purposes, of £500,000. The application of this concession needs to be carefully considered and proper advice sought.
Defendants
It is important to note that the tax treatment of damages or compensation is not the same for claimants and defendants and defendants should also obtain tax advice on how best to treat payments. For example:
- Compensation payments made by companies may be deductible against trading profits or may be treated as allowable expenditure if the payments incurred are “wholly and exclusively” for the purpose of the trade.
- If the defendants’ business is an investment business, the defendant may be able to claim that the compensation paid is a management expense.
- If the claim results in the defendant receiving a fine or penalty from a regulator, or any other punitive damages, the starting point is that those payments are not deductible.
In summary, tax should always be considered early on in any settlement discussions. Any potential tax liabilities can significantly impact the quantum of any settlement and claimants in particular, may want to factor in tax liabilities to any offers made or accepted in settlement discussions.
Further information
If you have any questions or concerns about the topics raised in this blog, please contact Krishna Mahajan.
About the author
Krishna is a Senior Associate in the Dispute Resolution Team, who specialises in litigation and resolution of complex tax matters.
We welcome views and opinions about the issues raised in this blog. Should you require specific advice in relation to personal circumstances, please use the form on the contact page.
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