Compensation and tax
What’s the tax status of compensation payments received? This is an interesting point and HMRC has recently issued a statement, changing its policy on the treatment of certain payments.
- Compensation for personal injury, whether physical or mental (e.g. discrimination) is tax-free.
- Compensation for financial loss related to an asset is taxable (e.g. compensation paid by an estate agent or solicitor to you for delays in the sale of your buy-to-let property caused by them would be treated as additional proceeds from the sale of the property and therefore subject to Capital Gains Tax.
- Compensation payments made to your company, to make up for lost income or profit, is generally taxable as trading income of the business. An example would be where a supplier compensates your company for cancelling a contract. However, companies here may be able to escape tax if they can show that the loss of a contract was tantamount to the cessation of their trade. For example, if your company is heavily dependent on one large customer and that customer terminates their contract early, paying compensation to your company, HMRC will, under pressure, accept that the compensation is not taxable.
- If you’re entitled to sue for compensation and the other party pays you not to take action then the compensation is taxable, but only if it exceeds £500k. Payments made in respect of mis-selling are a classic example.
Whether the compensation is taxable or not, any interest added to the payment (maybe because it has taken years to agree) is always taxable and needs to be declared on the tax return.