Direct tax treatment of damages and compensation payments
Direct tax treatment of damages and compensation payments

The following Tax practice note provides comprehensive and up to date legal information covering:

  • Direct tax treatment of damages and compensation payments
  • The claimant—is the payment income or capital?
  • Compensation for loss of profits
  • Compensation for revenue expenditure
  • Sterilisation of a capital asset
  • Sterilisation need not mean destruction
  • Payments on termination of employment
  • Interest
  • The claimant—tax treatment of a capital receipt
  • Zim—an example
  • More...

Where a dispute is brought to an end by a payment of damages or compensation, whether under a court order or an out-of-court settlement agreement:

  1. the person receiving the payment (the claimant) will want to know whether that amount is taxable, and

  2. the person making the payment (the defendant) will want to know whether they can claim any tax relief

This Practice Note considers these two questions in turn, in relation to direct UK taxes. The parties will also need to know whether the payment attracts VAT, and this is considered in Practice Note: VAT treatment of damages and compensation payments.

Tax considerations may also be relevant to the calculation of the amount of the damages or compensation payment. This is considered in Practice Note: The effect of tax on the quantum of damages.

The claimant—is the payment income or capital?

The first step in deciding whether a payment of damages or compensation will be taxable for the person receiving it is to determine whether it is income or capital. This is because, under basic tax principles, the legislation imposing income tax, corporation tax and capital gains tax has separate rules for receipts of a capital nature, and receipts of an income nature.

If the receipt is income, it is highly likely that it will be taxable (subject to any losses or other reliefs the claimant may be able

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