The following is a look at the commonly over-looked possibility of a claim for tax exemption under Extra-statutory concession D33 (ESC D33) following the amendment which took place in 2014.

Isn’t all compensation tax-free?

No, lots of money can be called ‘compensation’. The tax treatment depends on what the ‘compensation’ is for and other facts.

Income

Where damages are paid to compensate for lost income such as trading receipts, savings income and employment income, it is taxed as income¹. For example:

• Being deprived of the use of money is interest and compensation is taxable as interest.
• A utility company digs up the road outside a shop with the result that the business suffers because it is difficult for customers to get in the shop. The utility company pays compensation for the loss of business. This compensation is taxed as part of profits.

Capital

Where the compensation paid is a capital sum rather than income it is potentially taxable to capital gains tax or corporation tax for a company (CGT/CT). This is because in Zim Properties Ltd v Proctor [1985] STC 90 the Court decided that the right to take court action for compensation or damages is an asset for capital gains tax purposes, often with little or no base cost, and the receipt of compensation is then a capital receipt that will be taxable. With basic rate taxpayers paying CGT at 18% and higher rate taxpayers at 28% (and CT at 19%) on the net figure (after exemptions, allowances and reliefs) that could be a sizeable chunk of the damages.

Extra-statutory concession D33

Following this decision HMRC introduced ESC D33 with two operative parts.

If the compensation can be linked to an asset which is chargeable to CGT/CT, the compensation is taxed as a capital gain on that asset and not by reference to the right of action itself (paragraph 9 ESC D33). HMRC considers that where there is an underlying asset, for example shares in a company or a building, the compensation is to be treated as derived from the asset. For example:

• Payments made under a warranty or other indemnity included as one of the terms of a contract of purchase and sale are chargeable to capital gains tax because there is a contractual right to receive them.
• Compensation paid by an estate agent or a solicitor (as in Zim) because his negligence led to the sale of a building falling through is treated as if it is a capital gain on the building.

If the compensation cannot be linked to an asset chargeable to CGT/CT, the first £500,000 will be exempt (Paragraph 11 ESC D33). (NB: Prior to 27 January 2014 the full amount was exempt²).

This limit presents a potential trap for the unwary and could result in some harsh outcomes for a Claimant. Compensation that would typically be affected by a limit would be for some kind of financial loss for example where losses have been incurred as a result of incorrect professional advice. HMRC cites the example of negligent tax advice. In the absence of a tax charge the Courts will normally order compensation, or its amount will be negotiated between the parties, to put the claimant in the same financial position as they would have been but for the fault. It would be unusual for a claimant to end up in a better position, so it seems strange that the compensation, whatever its level, should then be taxable.

For example:

• where an individual transfers cash, of say £2million to their solicitor for the purchase of a property, and that money is misappropriated. If the individual was eventually compensated by the solicitor’s insurer it would appear that £1.5million of the compensation would be taxable. But the compensation simply restores the cash and there is no profit to the individual. The cash was not a chargeable asset so it would seem anomalous to tax it.

It is possible to claim relief but HMRC has stated that it will only provide relief above the £500,000 limit in exceptional cases. Anyone who receives compensation of more and thinks it should not be chargeable to CGT/CT can make a claim in writing to HMRC.

However the claim can only be made once the size of the payment is known. This doesn’t help if you need to know for certain whether all the compensation or just the first £500,000 is exempt before accepting a settlement offer. In these circumstances it may be possible to:

• claim the compensation plus the tax that will (or may) have to be paid on it such that any compensation awarded or agreed would be grossed up (the “Gourley principle”) to cover the tax cost. Defendants will presumably respond by arguing either that they should not be liable to compensate the claimant for this tax at all or that, at the very least, the claimant may never have to pay the full amount of tax – because it may, for example, be able to claim allowable expenses (possibly including its legal costs in the very proceedings by which the compensation is claimed).
• Make the acceptance of the settlement conditional on HMRC granting relief. However this could delay receipt of the settlement sum for many months whilst HMRC consider the claim.
• Seek an indemnity from the defendant in the event that HMRC decides to tax the damages; however, the payment of such an indemnity might itself be subject to CGT/CT.

It is clear that the tax treatment of damages should be considered at an early stage as this may need to be factored into the amount claimed and in settlement negotiations to ensure the offer is enough.

Obviously if a settlement reached after 27 January 2014 has resulted in an unexpected tax charge independent legal advice should be sought as soon as possible.

¹All compensation paid because of any wrong or injury suffered by an individual personally rather than because of any financial loss e.g. for physical injury, distress, embarrassment, loss of reputation or dignity, unfair or unlawful discrimination and for libel or slander is exempt from CGT. (S 51(2) of the Taxation of Chargeable Gains Act 1992 (TCGA) and paragraph 12 of ESC D33.

²A formal consultation was published by HMRC in July 2014. It proposed that the concessionary elements of ESC D33 would be legislated, and that an increased limit of £1million should replace the £500,000 in the concession as it presently stands. No progress has been made in the consultation and so it is not clear whether the limit will be increased.