Practical issues around capital gains tax on damages awards

Posted: 10/07/2023

Where a damages award is made in the context of a commercial dispute, it will generally be the case that the recipient is liable to income tax (or corporation tax on income if it is a company) on the payment. In very simple terms, this will be the case if the payment is compensation for lost income and is a receipt of the recipient’s trade, business or employment.[1]

Where the payment is taxed as income, it cannot also be subject to capital gains tax (CGT). CGT only needs to be considered where the award is outside the scope of income tax.

CGT arises on damages because any sum received in settlement of a contractual right or other right to sue is treated, for tax purposes, as the proceeds from the sale of a capital asset. This is the case whether the payment is made under a court order or as part of an out-of-court settlement. The right to sue is itself a capital asset (a chose in action), separate from any underlying asset the damage to which caused the legal action.

This note is intended as a guide to establishing whether there is a CGT liability in the first place, rather than how to calculate the CGT liability, but you should be aware of the issues in determining the ‘base cost’ that is deducted from the damages award to calculate the taxable gain. The starting point will be HMRC’s extra statutory concession D33 (ESC D33).

There is a statutory exemption from CGT (section 51(2) Taxation of Chargeable Gains Act 1992) on awards for physical injury, distress, embarrassment, loss of reputation or dignity, unfair or unlawful discrimination, libel or slander (though bear in mind that, if these payments are made in a ‘work’ context, they could be taxed as employment income).

HMRC accepts that this statutory exemption also applies to compensation received for professional negligence in relation to a claim for damages that would itself have been exempt. For example, if a personal injury claim would have resulted in a (tax-free) award but for the solicitor’s negligence in allowing the claim to become time-barred, any compensation payment by the solicitor will likewise be exempt.

In other circumstances, where the compensation is for financial loss, such as compensation for negligent legal or financial advice or for mis-selling of financial products by banks to consumers, the strict legal rule is that damages awards are subject to CGT. However, HMRC (in ESC D33 referred to above) limits the legal position in two important ways:[2]

• where the claimant is suing for destruction of, or damage to property or to some other physical asset, the award may be treated as proceeds from the sale of the underlying asset. This allows the claimant to treat at least some of the original cost of the asset as deductible ‘base cost’ in calculating the chargeable gain on disposing of the chose in action. It also means that, if a specific CGT exemption would have applied on disposal of the underlying asset (such as cars or one’s main residence), the damages award will also be exempt; and
• where the legal action does not relate to any physical property, the damages award is exempt up to a financial cap.

This second concession was made more complicated by the introduction of the financial cap almost a decade ago. Until 2014, HMRC accepted that any damages payment, of whatever amount, that did not relate to damage to, or destruction of, a physical asset was exempt from CGT.

In January 2014, HMRC announced that its concessionary treatment would be limited so that only awards up to £500,000 would be automatically exempt. The concession would not apply automatically to any excess above £500,000.

However, HMRC allows that the recipient of the award can make a claim to HMRC for the CGT exemption to apply to the excess. In the absence of a claim and a favourable ruling from HMRC, CGT must be paid on the whole of the excess. The CGT rate is 10% for basic-rate taxpayers and 20% for higher and top-rate taxpayers.

The chargeable gain would have to be declared in a self-assessment return by 31 January of the year following the end of the tax year in which the payment was made. If the recipient doesn’t already file tax returns, they may need to register with HMRC to request a return.

A claim to HMRC for exemption could be made in the recipient’s self-assessment tax return. However, HMRC accepts – and it is the norm – that a separate claim can be made as soon as the amount is fixed (ie before the payment is made). The claim must state the circumstances of the award, details of the payer and of the recipient and the amount of the award. It should then be sent to the HMRC office that processes the individual’s tax returns. If there is no CGT to pay because the award is less than £500,000, it is not necessary to file a return to claim the exemption.

In its CGT guidance, HMRC states that claims that meet specified circumstances will be accepted. These cover claims for mis-selling of a financial product by a regulated entity by the person who has suffered the loss (though not to a third party to whom the right to sue has been assigned). In our experience, HMRC is willing to issue confirmations in other circumstances of professional negligence (and does so within the 30 working days that is HMRC’s stated target).

Adjustments of damages awards to take account of tax

The Gourley principle (from the 1956 case, British Transport Commission v Gourley) requires the courts in particular circumstances to adjust the quantum of damages upwards or downwards depending on whether the damages award will suffer more or less tax than the tax that the claimant would have had to pay but for the action of the defendant that has led to the claim.

Parties to potential legal actions, and their lawyers, will equally be aware of this principle in reaching an out-of-court settlement.

Gourley concerned loss of earnings as a result of personal injury, and most instances where the courts have adjusted an award to take account of tax have been in the area of loss of earnings – where both the financial loss and the compensating award would now be subject to income tax rather than CGT. However, there is no reason why the principle does not apply equally to CGT liabilities on damages awards.

In the context of CGT, the more common situation is where the damages award is subject to higher taxation than the claimant would have had to pay but for the defendant’s actions, so the award needs to be adjusted upwards ie ‘reverse Gourley’. This is likely to be the case if it is not a (tax-exempt) personal injury claim and there is no damage to physical property.

There are practical problems for litigation lawyers determining whether a damages award should be adjusted to take account of tax.

First, the courts have not been consistent in applying Gourley. There are instances where the courts have refused to adjust an award where the tax treatment is uncertain or where there are multiple claimants who will each pay tax at different rates, thus making the quantum of the adjustment hard to calculate. There are also instances where a higher court has adjusted the quantum of damages because the actual tax liability has turned out to be different from the estimated tax which a lower court had used to compute the award.

In the 2020 litigation between Ernst & Young and one of its former partners (Rihan v Ernst & Young Global Limited [2020] EWHC 1380 (QB)), the High Court went so far as to order the claimant to seek a ruling from HMRC on the quantum of the tax liability on the damages award.

This leads on to a second problem for litigation lawyers. As mentioned above, a claim to HMRC for exemption of a damages award larger than £500,000 needs to state the amount of the award, but what happens where the amount is contingent pending confirmation of the tax treatment? We are aware of such a claim having been rejected by HMRC, but our experience is that HMRC will accept a claim for a specified amount that is fixed, save that it might be adjusted downwards if HMRC confirms there is no CGT to pay. We have obtained successful determinations that there is no tax to pay in those circumstances.

Justifiably, HMRC takes the view that it is not bound by any assumption as to the tax liability on a damages award made by court order or out-of-court settlement. Given that tax is collected under self-assessment, once all the negotiations of the damages award are complete, recipients of awards are still responsible for declaring the correct tax regardless of any tax adjustment that a court, or lawyers, have made.

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