Claimants who are looking to settle their claim by way of receiving a sum of damages will need to consider the tax position at an early stage. It is important to have a full understanding of the tax position before accepting any settlement offer, as tax may need to be factored into the settlement negotiations and possibly the amount claimed. The below note provides some general guidance as to how damages may be taxed, however this is largely based on the facts of each claim. For more specific advice on your circumstances, speak to an accountant, or alternatively one our legal advisors at Stephens Scown may be able to help.
Income vs Capital
The main distinction between tax treatment of damages is whether the damages are income or capital in nature. Whilst the distinction between the two is not completely clear, generally, damages which cover loss of profits or trading expenses will be treated as income, whereas damages which relate to a loss on a business’ capital basis, such as destruction of an asset, are likely to be capital. It is important to note that just because damages relate to an asset or property that does not necessarily mean that it is capital in nature – for example, if the consequence of the action is that a physical asset cannot be used and therefore is not generating trading profits, the damages may be income related, i.e. to cover loss of rental income for example.
Income Damages
Where the receipt of damages is income related, it will be taxable if it falls under one of the main categories of taxable income; such as trading income, property income, employment or savings income. Damages that fall within these categories will be subject to income tax or corporation tax (depending on whether the claimant is an individual or a company). Some exemptions to this apply where the damages are for personal injury claims (see below on Compensation). It is important to consider any losses or other reliefs that the claimant may be able to use before tax, as well as any interest on the damages, as this will also be subject to income tax!
Capital Damages
Where damages are capital in nature and are derived from an asset, the payment will likely be chargeable to capital gains tax (CGT) or corporation tax on chargeable gains. Extra-Statutory Concession (ESC D33) governs this; and provides that where compensation relates to a form of property that is itself an asset for CGT purposes, the compensation may be treated as deriving from an underlying asset. The claimant will therefore be taxed as if it has sold part of the asset and the receipt of the damages will be treated as a deemed disposal. Where the compensation is applied to restore the capital asset to which the claim relates, HMRC allows the tax charge to be postponed so that the compensation is not taxable when received by the claimant.
Where there is no underlying asset for capital gains purposes, the damages may be derived from the right to sue, which has no base cost for CGT purposes and may therefore be exempt from tax. The tax exemption for claims with no underlying asset is however limited to £500,000.
Compensation
Compensation in the form of damages may be awarded to a claimant in recognition of loss, suffering or injury. Statute says that any wrong or injury suffered by an individual in his person or his profession or vocation is exempt from CGT. Therefore claims for personal compensation, such as suffering and injury, are exempt from capital gains (and income) tax. HMRC have set quite a wide definition of injury, which includes ‘distress, embarrassment, loss of reputation or dignity’ which may include unfair discrimination and defamation.
Conclusion
The general position of taxation on damages is that the claimant should be put back in the position that they would have been in had they not suffered the loss – therefore they should not be placed in a worse or better position as a result of the action giving rise to the damages than if the action had not occurred. This is the position that the Courts would take if they were to assess the issue. The best course of action when negotiating a settlement is to speak with your accountant for tax advice. For further advice on damages and litigation more generally, speak to one of our trusted advisors in the dispute resolution team at Stephens Scown.