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Tax on Compensation Payments: More Than Just a Commercial Concern
When parties enter a commercial settlement involving compensation, tax is often treated as an afterthought. But in reality, it plays a crucial role in how much is received, how much is paid, and how fair the deal really is once tax consequences are taken into account.
Whether you’re receiving a settlement or paying compensation, understanding the tax implications is essential to ensure neither side ends up worse off than expected. The key lies in identifying what the payment is actually for.
Income or Capital: What’s the Payment For?
There’s no blanket rule that compensation is tax-free. Instead, the tax treatment depends on why the payment is being made:
- Loss of profits or trading income is usually taxed as income.
- Wasted revenue expenditure is also treated as income.
- Compensation for damage to capital assets (like property or shares) may fall under capital gains tax.
Each case must be examined individually, and the components of the payment must be carefully analysed. One settlement may include amounts for lost profits (income), replacement of damaged equipment (capital), and other elements.
For example, a business receiving a lump sum because of a contract breach may find part of the compensation taxed as trading income, while another part may be considered capital if it relates to lost or damaged assets.
Settling Capital Claims
Sometimes, payment is clearly capital in nature—say, when a business receives money for the collapse of a property sale caused by negligence. Even in these situations, a capital gains tax charge could apply, depending on whether the compensation relates to an underlying asset.
If the payment can be linked back to something the recipient owns, like a property, part of the cost of that asset may be offset against the compensation received, reducing the tax liability. If not, a general exemption may apply for smaller amounts—but it still needs to be reviewed case by case.
The Gourley Principle: Adjusting for Tax Impact
One of the most important—and often misunderstood—concepts is how tax should influence the actual amount of a settlement.
When someone receives compensation for lost income, the natural assumption might be that they should get the full amount they would have earned. But if that income had been taxable, the person could have ended up better off unless the compensation was reduced to reflect that tax.
This is known as the Gourley principle, and it helps ensure that the recipient is compensated for their net loss—not more, not less. If the recipient’s tax rate is lower in the year they receive compensation than it would have been when the income was originally lost, the award might be adjusted downward.
When the Tax Cost Is Higher
The reverse scenario can also happen—where the recipient ends up paying more tax on the compensation than they would have on the original income. This can happen if the income is spread over the years, but the compensation is paid all at once, pushing the recipient into a higher tax bracket.
Although the law doesn’t currently require this kind of adjustment, there is an argument that settlements should reflect this, especially when negotiating. It’s an area where good legal and tax advice can make a real financial difference.
Mitigating Tax: Is the Recipient Doing Enough?
From the payer’s perspective, there’s also the question of whether the recipient has done enough to keep their tax exposure as low as possible.
For example, if compensation includes VAT that the recipient should have recovered but didn’t because they failed to register for VAT, should the payer still cover that cost? In some situations, it may be fair for the payer to ask the recipient to take action—such as registering for VAT or claiming reliefs—before finalising the amount.
This concept aligns with the broader legal principle that the recipient of compensation should take reasonable steps to mitigate their losses.
Practical Steps for Businesses and Individuals
Here’s what you need to consider when compensation payments are on the table:
- Break Down the Payment: Understand what each part of the compensation is for. Is it for loss of income, asset damage, or something else? The answer changes the tax outcome.
- Consider the Timing: When the payment is received, it may affect which tax year it falls into and what rate of tax applies.
- Model the After-Tax Outcome: Calculate how much will actually be left after tax, not just the gross figure. This is particularly important in negotiations.
- Explore Reliefs and Exemptions: Capital elements may be eligible for tax reliefs or exemptions, but only if the conditions are met, and the claim is properly prepared.
- Get Advice Early: Tax issues are much easier to resolve before a settlement is signed. Waiting until the payment hits the account could mean missing planning opportunities.
Tax Shouldn’t Be an Afterthought
When compensation payments are involved, the tax must be part of the discussion from day one. Whether you’re a business settling a dispute, an individual receiving a payout, or an advisor guiding clients through the process, understanding the true tax impact ensures the outcome is fair—and that nobody ends up with less than they deserve.
Need Help Structuring a Compensation Payment?
At Tax Accountant, we help individuals and businesses navigate the tax implications of settlements with clarity and confidence. From analysing payments to advising on optimal structures, our team ensures you avoid surprises and keep more of what you’re entitled to. Get in touch today for tailored tax advice on your next commercial settlement.