Article by Arthur Sellwood, former Inspector of Taxes, published in the July 2001 issue of "Tax Adviser". Compensation, for its recipient, represents the restitution of, or requital for, the loss of something valuable, whether from a personal or a business or a financial aspect. The loss may be of the thing itself or of rights over it or past, present or future entitlement to profit from it. Losses may include injuries or wrongs suffered by the claimants. The valuable asset may even include human life itself where the claimant is a spouse or relative or even an employer claiming in respect of someone's death before his appointed time. The compensation may be provided voluntarily or arise from contractual obligations; it may be a requirement of governmental laws or regulations or be recovered by a successful process in the courts. Since such compensation is normally a monetary payment, it may be expected to have taxation repercussions. This may be so even when the compensation in question is of relatively small scope or arises in only a small field. For instance, in the last two or three years questions have arisen as to the taxability of compensation paid by banks on dormant accounts opened by subsequent holocaust victims and of compensation received by persons who had been mis-sold concessions and exemptions. Of wider significance are the many Schedule E cases concerned with what used to be called 'compensation for loss of office' which taxpayers claimed to be non-taxable capital receipts rather than emoluments of the offices or employments which gave rise to them and which are now usually referred to as termination payments.
Schedule D - Cases I and II
It is, however, to be expected that the widest field for the payment of compensation is that relating to business. A trader or his professional counterpart may, on occasion, have to pay compensation as well as to receive it and there is a large body of case law covering both receipts and payments in such circumstances. Clearly compensation in all its aspects is too large a subject for a short article of this type and it is, therefore, proposed to consider only receipts of compensation by those liable to tax under Cases I and II of Schedule D. But mention may be made of principles emerging from cases dealing with payments in this field or, indeed, in other fields where compensation is involved.
Receipt of compensation by a businessman is, of course, at present a very topical matter in view of the widespread problem of foot and mouth disease. Arrangements have, however, been made by this journal to give competent coverage to this as a problem in itself. It is not, therefore, proposed to discuss the problem in this article except to say that treatment of this particular form of compensation is likely to be in line with the more general rules set out below, except that the Taxes Act 1988 Schedule 5 provides by statute for cases covered by a herd basis election.
An old argument
Before capital gains tax was introduced, the essence of arguments about the treatment of compensation was whether sums received or paid represented capital or revenue. The taxpayer would argue that a lump sum received was capital and, therefore, not taxable, while the Revenue would contend that it represented a receipt of taxable profits. Conversely, a taxpayer who was called upon to make a compensation payment would claim it as a deductible expense whilst the Revenue would try to show that it was capital outlay and, therefore, inadmissable.
A proposition that was much used by those wishing to demonstrate that a particular receipt or payment of compensation was capital rather than revenue was that it was to cover the loss or disturbance of the whole structure of the business rather than the mere loss of part of the trading receipts. An important case in which this point was made was that of Van den Berghs Ltd v Clark 19 TC 390. A UK company had made a profit-sharing arrangement with a Dutch company and, when it broke down, the UK company received a large sum as damages. This was held to be capital because the pooling arrangement related to the whole structure of the company's profit-making apparatus. In contrast, many items of compensation, both those received for the loss of an agency and those paid to others for cancelling an agency agreement, have been held to be of a revenue nature as, for instance, in Kelsall Parsons and Co v IR Commrs [1938] 21 TC 608. But in Barr Crombiee and Co Ltd v IR Commrs [1945] 26 TC 406 a payment to ship-managers who had lost almost their entire business was held to be capital.
With the advent of capital gains tax the importance of making a distinction between capital and revenue has lessened but, because of reliefs and allowances or the existence of unused capital losses, it may still be advantageous to claim that a receipt of compensation is capital. Where such claims are made the old question of whether the compensation is for the loss or disruption of the whole business structure still comes into play. In the case of A Consultant v HMIT [1988] Sp C 180, the Special Commissioner gave as his reason for saying that the compensation received was not of a capital nature that the termination of the agreement giving rise to it certainly did not affect the whole structure of the profit-making apparatus.
Other capital aspects
Reference to the whole structure of the business may not, of course, always be the appropriate pointer to the capital nature of a particular item of compensation. Where, on the facts of the case, it is clear that the compensation is for the loss of a fixed asset or for the permanent deprivation of the use of such an asset, even where it is an income-producing one, it is likely to be a capital receipt as in the case of the sum received by a fire-clay company from a railway company for leaving some of its fire-clay beds permanently unworked in Glenboig Union Fireclay Co Ltd v IR Commrs 12 TC 427. Where, however, the loss of the asset is only temporary and the compensation can be shown to be intended to make good the loss of income whilst the asset is out of commission it is likely to be treated as a receipt of the trade as in the case of Ensign Shipping Co Ltd v IR Commrs 12 TC 1169.
Recourse to Schedule E
By reason of TA 1988 s188(4) compensation that is correctly assessable under Schedule E may include a tax-free element. Some professional men assessed under Case II of Schedule D have been successful in claiming that compensation which they have received should be relieved from tax in this way. Although such a claim was unsuccessful in the case of Blackburn v Close Bros Ltd [1960] 39 TC 164, where compensation for the termination of an agreement to provide secretarial services was held to be a trading receipt, some other claimants did rather better as, for instance, in respect of compensation for the reliquishment of auditorships in Ellis v Lucas [1966] 43 TC 276 and for the loss of a registrarship in IR Commrs v Brander and Cruikshank [1969] 46 TC 574. One wonders whether there might be some hidden solace here for the victims of the recent IR35 legislation!
Voluntary and unexpected payments
The fact that compensation is paid voluntarily gives no guarantee that it will escape tax. In Rolfe v Nagel [1980] 55 TC 585, a payment by one diamond broker to another under an arrangement that had no legal force was held to be a trading receipt. In McGowan v Brown and Cousins [1977] 52 TC 8, an ex gratia payment to a firm of estate agents was similarly treated. In the first mentioned case, the courts indicated that a decision in such cases should have regard to the character of the receipt in the hands of the recipient rather than to the motives of the payer. Nonetheless, an ex gratia payment for the loss of auditorships by a firm of accountants in Walker v Carnaby [1969] 46 TC 561 was held to be non-taxable, as was a payment by brewers to compensate a catering firm for the loss of tenancies in Murray v Goodhews [1976] 52 TC 86.
An increasing practice
In Tax Bulletin Issue 32, the Revenue stated that it had become an increasingly common practice among utility companies and others to pay compensation to customers for interruptions and deficiencies in their service, and that the Revenue had been asked how such compensation should be treated in the hands of those carrying on a trade or profession. It was said that two principal questions needed to be considered, viz:
1. Did the compensation arise from the business activities?
2. Is the compensation of a revenue or of a capital nature?
Where the compensation relates to specific services used wholly by the recipient it would almost invariably arise from the business even if there is no specific legal right to it. Where the services involved are used for private as well as business purposes, the part referable to private usage is not a business receipt. It has to be considered whether compensation involving services for business purposes is of an income or capital nature. It is likely to be income unless it is to make good damage to or for the physical destruction of a capital asset. Where it is for making good damages it should go to reduce any claim for deductible repairs.
The tax factor in damages
A principle adopted in British Transport Commission v Gourley [1955] 3 ALL ER 796 was that an award for damages should take into account a deduction for the hypothetical tax. In Pennine Raceway Ltd v Kirklees Metropolitan Council (No. 2) [1989] STC 122, the Lands Tribunal had made a deduction on the assumption that the compensation would not be taxable. The Revenue, however, viewed the compensation as taxable, and the company appealed to the courts agains the Lands Tribunal's award. The court held that the compensation was taxable and had been wrongly reduced by the tribunal.
In Deeny v Gooda Walker Ltd [1996] STC 299, the question arose whether damages against their agent awarded to Lloyd's Names should be reduced by the tax saving obtained. The courts held that the damages arose as part of the trade and would be taxable, so that no reduction should be made in the damages paid.
Technical Department
020 7235 9381
July 2001 by Arthur Sellwood
