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Will your damages be taxable?

Awards and settlements in commercial disputes can be taxable in the claimant’s hands. The tax treatment of damages should be considered at an early stage as this may need to be factored into the amount claimed. Tax also needs to be considered in settlement negotiations to ensure the offer is enough.

This guide was last updated in July 2017

Income or capital?

The first issue affecting the tax treatment is whether the damages are income or capital in nature for the recipient.

The distinction between income and capital is complex. However, the general rule is that if the damages are to compensate for a loss of income, then the damages are themselves of an income nature, and are therefore taxed as income. However, where the compensation for loss of income relates to the whole structure of the recipient’s trade, it is capital.

Where the payment relates to a capital asset (such as a property or shares), it will usually be capital in nature.

Damages which are income

If the damages are income in nature they will only be taxable if they fall within one of the categories of taxable income such as receipts of a trade or profession, receipts from a property business, savings income or employment income. There are also some exemptions which are more relevant to individuals, such as personal injury damages.

An example of a trading receipt is debt recovery where goods have been sold or services supplied – although in this case the trading receipt will usually have arisen by reference to when the sale took place and not when payment was made.

Damages from a loss of profits claim will usually also be trading receipts.

Damages which are capital

Where the damages are capital rather than income in nature the tax position is principally governed by an Extra Statutory Concession, D33. 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.

A good 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 tax exempt treatment where there is no underlying asset is being whittled away by HM Revenue & Customs (HMRC). In January 2014 HMRC amended D33 to limit the exemption to £500,000. Whilst relief can be granted for awards in excess of this £500,000 threshold, it must be claimed from HMRC, and in the case of corporates is unlikely to succeed. The claim can only be made once the size of the payment is known, which may be too late to influence the quantification of the claim or negotiation of the settlement.

In 2014 HMRC consulted on a proposal to limit the exemption to £1 million with no possibility of applying to HMRC for relief for higher sums. This would mean awards in excess of £1 million would be taxable to the extent that they exceed £1 million. However, consultation responses were not favourable and, although the government said it would consider the proposal further, no further announcements have yet been made.