Are compensatory damages considered taxable income?
There are many types of damages awarded to both individuals and businesses. They include such things as breach of contract, personal injury and misleading financial advice. In broad terms, compensation is not subject to tax, neither is the interest earned up until the time that the award is made. That last point is important – if the payment is delayed and interest is added in the meantime, then that interest is taxable, and should be declared as income. Similarly, if you invest your compensation payment in an interest-bearing account, then that too is subject to tax.
Breach of contract
Payments awarded for breaches of contract are subject to scrutiny using the “Gourley principle.” According to Hui Ling McCarthy of Gray's Inn Tax Chambers, this means: “That a person must not be placed in a better or worse position as a result of a breach of contract than if the contract had actually been performed.” Therefore, the payment awarded is the amount the person would have received net of tax and is not subject to further tax. Interest is treated as mentioned in the introduction.
Personal injury damages
Payments made for accidents where the fault lies with another are treated in various ways, dependant on the reasons for the compensation. If the payment is for loss of earnings during recuperation, then it is subject to the Gourley principle, and tax is built in to the payment, though in practice, no tax is paid to HMRC. For example, a person is awarded £1,000 for the loss of wages and would normally pay £200 tax on that income. The Gourley principle is applied and the payment is reduced to £800 to reflect net earnings. All other payments made to accident victims are tax-free, including interest up to the date of the award.
Children who receive payments in respect of vaccine damage are not liable for tax until they reach maturity and apply for tax credits. Any income being received from the damages, i.e. annuity payments, are then treated as investment income and subject to tax.
Misleading financial advice
Commonly known as “bad advice,” this covers the mis-selling of financial products, whether they be PPI (Payment Protection Insurance), investments, endowments, personal pensions or mortgages. This type of compensation is treated the same way as other damages, i.e. the capital amount is returnable, plus interest, which is tax free to the date of the award. However, there are restrictions and stipulations regarding certain bad advice payments, so check with a solicitor and/or HMRC.
Damages awarded for termination of employment
Termination of employment damages are payable in such circumstances where the employer has ended the employment without notice. These situations are generally grouped under the heading of “redundancy,” and payments are tax-free up to £30,000. All subsequent interest earned on the payment is taxable and must be declared to HMRC.
- Gray's Inn Tax Chambers: The Tax Treatment of Damages & Compensation; Hui Ling McCarthy
- HM Revenue & Customs: SAIM2330 – Interest – exemptions, personal injury damages
- HM Revenue & Customs: SAIM2340: SAIM2340 – Interest – exemptions, compensation for mis-sold pensions
- HM Revenue & Customs: TCTM04730 -- Vaccine Damage Payments -- Payments under the Vaccine Damages Act 1979