Q&A: When does tax apply to compensation

Q&A: When does tax apply to compensation

Determining the taxable status of individuals' compensation receipts can be complex

Q: Are individuals’ compensation receipts taxable?

A: The answer is, it depends why the compensation is being awarded. Compensation is defined as something, typically money, awarded to someone in recognition of loss, suffering, or injury.

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Compensation is distinct to non-taxable refunds, which can sometimes be incorrectly described as compensation. To determine taxability of compensation, it is first necessary to determine whether the compensation is an income receipt or capital receipt and whether it is in respect of a loss, or injury.

A payment in respect of a loss of income is not specifically exempt from income tax. It is generally quite easy to determine an income receipt. For example, compensation for loss of earnings is a payment directly linked to the income of the recipient. It is generally accepted practice that compensation for loss of earnings should be claimed in respect of the net loss after tax. The employee should be put back into the same financial position that they would have been in, had they worked – that is, the loss of net pay.

The compensation payment will then be treated by HM Revenue & Customs as exempt in the hands of the recipient. This is known as the Gourley principle. Compensation that is claimed and paid gross is generally considered by HMRC to be taxable, because it is in excess of the actual financial loss suffered and thought to contain some element of reward – otherwise the employee is actually better off than if they had worked.

Consider an individual who has suffered because of a breach of contract and that individual has a right to take action as a result. The right to take action for compensation is a chargeable asset and the ‘disposal’ of that asset, that is, the settlement of the claim, may be a chargeable capital event. The taxability of the compensation then depends on how the right to take action arose.

Compensation for personal suffering and injury is exempt from capital gains (and income) tax. The exemption applies to ‘compensation or damages for any wrong or injury suffered by an individual in his person or in his profession or vocation’. HMRC sets a wide definition of injury, so that damages or compensation for ‘distress, embarrassment, loss of reputation or dignity’ such as unfair discrimination and defamation are not chargeable.

By concession, HMRC provides reliefs and exemptions for compensation which is chargeable to capital gains tax.

If there is an underlying capital asset, HMRC will allow all or some of the tax base cost of the asset to be deducted to calculate the taxable element of the consideration. A common example is a financial loss is where an individual has suffered because an agent failed to act in time and as a result a sale of land fell through. The land is a capital asset and the receipt of compensation is taxable disposal proceeds but HMRC allow some of the cost of the land to be deducted.