Tax Implications of Settlements

by | Feb 19, 2014

Just think about what happened in the Barden mediation, Barden v Commodities Research Unit International (Holdings) Ltd and others 2013 EWHC 1633.  The parties did not discuss the tax implications of settlement in the mediation and the mediator did not ask.  When the settlement sum was paid net of tax to the surprise of the Claimant, proceedings continued and in the interests of justice, the court ordered everyone concerned with the mediation to ignore privilege and confidentiality and produce documents, witness statements and attend the trial.

Settlements are not neutral from tax.  Sums paid may attract income tax if they are compensation for income or capital gains tax if they are compensation for capital.  Some may be made up of elements of both and attract both to each part.  Of course, VAT may be payable too if the compensation relates to something vatable.

Mitigating tax or improving tax efficiency is OK but avoiding tax is not.  This is where lawyers need to have specific advice for their clients or recommended that their clients take it elsewhere.  Mediators may end up hauled before the court if they do not ask.  It may be the big elephant in the room that everyone is avoiding dealing with although it clearly needs to be.

London & Thames Haven Oil Wharves Ltd v Attwooll 1967 43 TC 491 established that if compensation is income related, damages are likely to be liable to income tax.  There are lots of cases but things like loss of earnings, interest, profits, rental payments, trading stock, loss of profits and usage of capital assets are likely to attract income tax.

The payer of compensation may achieve tax relief against income in the same way as it would if the payments had been made before breakdown of relations.  Likewise payments relating to capital costs and prices of capital items may create capital gains tax reliefs.

With regard to CGT (capital gains tax) there is since 27 January 2014 a change in the concession set out in D33.  If compensation is paid as a capital sum it may attract corporation tax by a company but it will need to be assessed as to whether there is a capital gain.  If it is linked to a capital asset, liability to CGT is likely. Before 27 January 2014, if a payment could not be linked to an asset chargeable to CGT, the compensation was automatically exempt from CGT.  This is changing so that only the first £500,000 of capital compensation not linked to an asset is exempt.  Any sum above that can be the subject of an application to HMRC to be exempt.  The exemption does not apply if the payment is linked to an asset.

If compensation is paid for personal injury, loss of reputation, discrimination, defamation or any other wrong or injury suffered by an indiviudal person it is exempt because of Section 51(2) Taxation of Chargeable Gains Act 1992 (TCGA) and paragraph 12 of D33.

Thanks to Felicity Cullen QC and good tax barrister.