UK government thinking further about proposed £1 million cap on tax exemption for damages

“None of the respondents agreed with this proposal. Most suggested that any limit would be, to some degree, arbitrary and several disagreed with the principle of taxing compensation and damages at all” the response said. "Before determining the next course action it is the government’s intention to discuss the issues in more detail with [respondents to the consultation] to ensure that the concerns they raised are fully understood."

Tax expert Ian Hyde of Pinsent Masons, the law firm behind Out-law.com said "It is good news that the government is listening and has not yet decided to press on with the change regardless. However, it is disappointing that it has taken over a year for the government to say that it has not yet made up its mind what to do."

"Those engaged in litigation need to know how their damages will taxed. If the damages are going to be taxable, claimants will want the tax consequences to be taken into account in the assessment of their loss, effectively resulting in the damages being 'grossed-up' but this is difficult if the tax treatment is not certain" he said.

In commercial disputes where damages are capital rather than income in nature, the capital gains tax (CGT) consequence of the receipt of the damages is principally governed by ESC D33. An ESC is a relaxation which gives taxpayers a reduction in tax liability to which they would not be entitled under the strict letter of the law.

ESC D33 was introduced following the High Court decision in a case concerning Zim Properties Ltd, which decided that the right to take court action for compensation or damages is an asset in its own right for CGT purposes. This meant that, if the ESC had not been introduced, in many cases the whole of the damages would be subject to CGT and various exemptions and reliefs would not be available.

ESC D33 states that 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 can be tax exempt. An 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 concession previously stated that where the damages did not relate to an underlying asset, they would not be taxable. However, in January 2014, HM Revenue & Customs (HMRC) amended D33 to limit the automatic exemption to £500,000. The amended ESC provides that, whilst relief can be granted for awards in excess of this £500,000 threshold, it must be claimed from HMRC.

In July 2014 the government published a consultative document proposing that ESC D33 be put on a statutory footing.  One of the proposals was to introduce an absolute limit of £1 million to the exemption from CGT for compensation derived from a right of action where there is no underlying asset. This would mean that any amount received above £1 million would be chargeable to CGT.

In the response document the government said “a number of respondents expressed concerns about taxing compensation, on the grounds that such payments simply put the parties back in the position they would have been in but for the negligent action. On this basis they considered it wrong to tax claims for damages for any amount."

Although the government said it agreed that many claims to compensation or damages are simply intended to put the claiming party back in the position they would have been in, if it were not for negligent action, it said it did not agree that "all payments badged as damages or compensation" should be exempted from CGT.

The government also said that concerns had been raised about how the proposals might impact upon creditors of insolvent companies. Insolvency practitioners may make substantial claims against officers of the company, professional advisers or others and if tax were to be charged on sums received under such claims this could reduce amounts available for distribution to creditors and effectively bestow a preference on HMRC in relation to other creditors.

The government is proposing to put ESC D33 on a statutory footing because in 2005 the House of Lords decided that the scope of HMRC’s administrative discretion to make concessions that depart from the strict statutory position was more limited than had previously been thought.  HMRC is therefore reviewing all of its concessions and putting into legislation those that it thinks go beyond its discretion.