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  5. Tax rules for compensation and settlements: when are they considered capital gains?

Tax rules for compensation and settlements: when are they considered capital gains?

13 November 2014

What is this about?

HMRC recently changed the way certain types of settlements or compensation are treated for capital gains tax purposes and it wants to change their treatment again soon. The Law Society is liaising with HMRC over these changes in order to achieve the best possible outcome for members.

Who is affected?

It is important to note that most cases won't be affected by these changes and that personal injury cases have long been exempted from capital gains tax pursuant to statute. The types of cases affected are set out below.

What is changing?

Up to January 2014, Extra-Statutory Concession (ESC) D33 had acted to prevent certain types of compensation from being subject to capital gains tax. These were cases in which it could be said that the compensation was not traceable to an underlying asset. In such cases, pursuant to a high court decision called Zim Properties, the acquisition of the right of action was regarded as an asset in its own right and the successful lawsuit was regarded as a disposal of that asset. ESC D33 effectively overrode Zim Properties so as to exempt cases from capital gains tax.

What is an extra-statutory concession?

An extra-statutory concession is a non-legislative measure that HMRC may use as a means of "tidying" anomalous issues at the margins of the code, where legislation would not be an apt solution.

When did the change come about?

In January 2014, HMRC changed ESC D33 so that only the first £500,000 of a judicial award or out-of-court settlement would be automatically exempt from capital gains tax. In order to claim an exemption for amounts over £500,000, it was necessary to make a claim to HMRC requesting that the whole amount be treated as exempt. HMRC had discretion as to whether to extend the exemption or not.

What is the current situation?

The current situation is that £500,000 is automatically exempt, with the possibility of obtaining an extended exemption upon application to HMRC. However, in June 2014, HMRC introduced three criteria that a person now has to satisfy in order to obtain an extended exemption. These are that:

  • The right of action was acquired in connection with goods or services that the payer - or a connected person (CG14580 et seq), associated company (CTM03530) or person acting in an intermediary capacity for the payer - has provided as part of their trade, profession or vocation (the first condition shall be considered to be met in all cases where the right of action relates to mis-selling of a financial product and the person who provides that financial product is regulated by the Financial Conduct Authority).
  • The payee did not acquire the right of action by means of a husband or wife's or civil partner's transfer (CG10790) or by a transfer within a group (CG45300+).
  • The payee did not acquire the right of action from another person for consideration (CG14500).

What are they trying to do now?

In July 2014, HMRC launched a consultation to legislate for ESC D33. This means that provisions meant to reflect the substance of the extra-statutory concession would be set out in law.

Under the new proposal, more types of cases would be subject to an unlimited statutory exemption but for some cases, there would be an automatic cap at £1million. Any amounts in excess of this would be subject to capital gains tax.

What is the Law Society's position?

The advantage of the new proposal is that it would be more difficult to amend the rules in future because they would be enshrined in statute. However, we believe that the changes that HMRC wants to make do not really reflect ESC D33 and could put claimants - or defendants - at a disadvantage. This is because either compensation awards will be grossed up in order to ensure that, after the tax has been taken out, claimants are in the position they would have otherwise been had the harm not occurred, or compensation awards will not be grossed up, meaning that the claimant will not be "made whole." We think this is unfair.

The Law Society is challenging HMRC's proposal by asking them to go further than they have in the consultation document, so that compensation is never subject to capital gains tax, except to the extent that it is awarded in respect of a lost or damaged asset which itself would have been subject to capital gains tax. We think that, given that HMRC has decided to legislate for ESC D33, it would be better and fairer to treat all cases in the same way.

What types of cases are affected?

The types of cases that would be affected by HMRC's current proposal would be those where it is not possible to identify a separate underlying asset (like a house, or a boat).

HMRC has indicated that it could affect financial mis-selling cases, though the courts could find that compensation in other types of cases should also be subject to capital gains tax, depending on whether it thinks a separate underlying asset can be identified.

As already stated, personal injury claims are already the subject of a statutory exemption from capital gains tax. HMRC proposes that the following types of compensation, which were previously exempt pursuant to ESC D33, should in the future be made exempt pursuant to the new legislation it hopes to introduce:

  • compensation for professional negligence claims associated with personal injury claims
  • compensation paid for any wrong or injury suffered by an individual in their trade or employment
  • compensation paid to a person other than the individual who suffered the wrong or injury, such as relatives or personal representatives of a deceased person
  • compensation for emotional distress caused by the death of another person, and
  • compensation for loss of financial support.

Under the new legislation, indemnities would also be disregarded for capital gains tax purposes until payment becomes enforceable and is, or has been, enforced. This would bring it in line with the treatment of other contingent liabilities. Similarly, this was already the case under ESC D33 and all HMRC is seeking to do is transpose it into legislation.

What happens if the changes go through?

The Law Society is seeking to ensure that all types of compensation where there is no underlying asset are exempt. However, in the event that the changes, as currently formulated, go through then we will make sure that clear guidance is made available to the profession to help guide members through the changes.