Mark McLaughlin looks at an instance where compensation receipts may be taxable as income, not capital.
A business could suffer a loss of income or profits through no fault of its own. This may result in entitlement to compensation or damages.
Income or capital?
The receipt of business compensation or damages may be treated as income or capital, depending on the circumstances. This distinction may be important for various reasons. For example, a capital receipt may be eligible for relief from capital gains tax (e.g., business asset disposal relief).
Unfortunately, the tax legislation offers little assistance in establishing whether business compensation or damages receipts are income or capital. This has resulted in numerous court cases in that area.
For a receipt to be treated as trading income, it must be a profit or gain arising in respect of the business. On the other hand, a chargeable gain can arise on the disposal of assets and on capital sums derived from assets, such as compensation for the loss of an asset.
Compensation for negligence
There is a specific exemption from capital gains for compensation or damages for wrong or injury suffered by an individual (but not a company) in their person, profession or vocation (TCGA 1992, s 51(2)).
This exemption is extended (by ESC D33, para 12) to compensation in respect of an individual’s trade, and can include damages for professional negligence. However, an income tax charge generally takes precedence over tax on a capital gain.
A 'hole' in profits
For example, in Gray v Lord Penrhyn, KB 1937, 21 TC 252, two employees at a slate quarry misappropriated funds. After discovering this, the auditors admitted negligence by a clerk and made good defalcations since they became the auditors. The court held this was a trading receipt.
More recently, in Charlton Chauffeur Drive Ltd v Revenue and Customs [2021] UKFTT 56 (TC), the appellant company ceased trading on 31 December 2015. An investigation of earlier irregularities by its then finance manager revealed that she embezzled an estimated £773,701 from the company between 2004 and 2012. From 2001, a consultant accountant (DE) had been engaged by the company. From 2007 to 2012, accountants (ABC) were engaged to audit the company’s accounts or provide accountant’s reports.
Following forensic investigations into the embezzlement and the conduct of DE and ABC, the investigators concluded that DE and ABC had both been negligent in performing their services. The company commenced proceedings against DE and ABC to recover the loss suffered. Ultimately, the action was settled by formal agreement, and DE and ABC agreed to pay £566,000. HM Revenue and Customs (HMRC) considered that the settlement should be treated as a trading receipt. The company appealed. The First-tier Tribunal (FTT) found that a distinction should be drawn between compensation filling a hole in a trader’s profits or in a trader’s assets (i.e., whether it was a revenue or capital receipt turned on the nature of the ‘hole’). The FTT found that the ‘hole’ in this instance was in the company’s profits. It was, therefore, a receipt of the trade and revenue in nature.
Practical tip
HMRC (in its Business Income manual at BIM40125) states that compensation for loss of profits due to negligence should be regarded as a trading receipt, even if there was no contractual relationship between the parties.
