Over the years I’ve been asked many times how court settlements should be taxed. I’m still surprised by the number of people who are under the impression that a special tax for compensation and damages exists – it doesn’t.
In order to determine the correct tax treatment of damages and compensation it is essential to establish what the payment relates to.
There are several possibilities, the main ones being:
1. Personal Injury Compensation
A total exemption from Income Tax and Capital Gains Tax may be available in the case of personal injury compensation payments and income arising from investments of such compensation payments provided the following conditions, as outlined in Revenue’s IT 13, are satisfied:
2. Compensation for Revenue Loss
If the compensation is for loss of earnings then the payment will be liable to Income Tax in the case of individuals and partnerships and Corporation Tax for companies.
Examples of compensation liable to Income Tax are as follows:
3. Compensation for Capital Losses
The main examples under this heading are as follows:
These capital sums will be liable to Capital Gains Tax and treated as if there was a disposal of the asset.
I recently came across this situation:
Recently I’ve received a number of queries relating to the Irish tax treatment of CFDs or Contracts for Difference. Although the information available is plentiful and appears to be straight forward, it’s important to be aware that each situation is different and as a result the tax treatment may vary considerably.
Firstly, what is a Contract for Difference?
Essentially it’s a contract between two parties i.e. the investor and the CFD Provider. At the close of the contract, the parties exchange the difference between the opening and closing prices of a specified financial instrument, including individual equities, currencies, commodities, market indices, market sectors, etc. In other words, two parties take opposing positions on the difference between the opening and closing value of a contract i.e. the price will rise versus the price will fall.
Contracts for Difference offer wide access to different financial instruments from a single account for a fraction of the cost of buying shares. They do not carry voting rights like ordinary stock and CFD trades on certain Irish stocks are not liable to Stamp Duty.
CFDs can be traded ‘long’ or ‘short’ to speculate on rising or falling markets i.e. the investor speculates that an asset price will rise by buying (long position) or fall by selling (short position).
CFDs do not confer ownership of the investment. Instead the investor has access to the price performance which includes any dividend or corporate action equivalent.
What is the Irish tax treatment for profits / gains?
Contracts for Difference are treated as Capital Assets liable to Capital Gains Tax UNLESS they are deemed to be held in the course of a financial trade in which case the profits are liable to Income Tax under Case I, Schedule D.
According to Revenue eBrief No. 36/2007:
“The contracts require two parties to take opposing positions on the future value of a particular asset or index. Investments are often made on a margin of 20% of the contract amount. As well as the difference in value of the asset from beginning to end of the contract period, certain other notional income flows are taken into account in calculating the overall gain or loss.
Where the contract is long (expectation of a rise in price), notional interest is a deduction and notional income a credit in the calculation.
Where the contract is short (expectation of a fall in price), notional interest is a credit and notional income a deduction.
The chargeable gain will be calculated on the gain or loss resulting from the computations above and including a deduction for all necessary broker fees incurred in the full contract.
Actual interest paid, if any, on the margin amount put up will be chargeable under Case III in the ordinary way and does not come into the CGT calculation.”
What’s the difference between holding Capital Assets and operating a financial trade?
The concept of a “trade” is a matter of interpretation and is usually determined by a number of factors known as “badges of trade.”
For example, a once off transaction would not normally be considered a “trade.” Depending on the circumstances and the timing it may be liable to Capital Gains Tax or indeed may be exempt from tax. If, on the other hand, the investor was involved in a large number of transactions throughout the year of assessment then this activity would be most likely be considered to be a trade and therefore liable to Income Tax.
What are the “Badges of Trade”?
There are a number of factors which will determine the existence of a “trade”. There is, however, no decisive test and no legislative definition. There is considerable case law concerning this issue and in 1954 a Royal Commission was set up in the United Kingdom to consider what factors should be taken into account in deciding whether a trade exists. A report was published outlining the “Badges of Trade” which are as follows:
1. THE SUBJECT MATTER OF THE SALE.
While almost any form of property can be acquired to be dealt in, those forms of property, such as commodities or manufactured articles, which are normally the subject of trading, are only very exceptionally, the subjects of investment.
Again, property, which does not yield to its owner an income, or personal enjoyment merely by virtue of its ownership is more likely to have been acquired with the object of a deal than property that does
2. THE LENGTH OF PERIOD OF OWNERSHIP.
Generally speaking, property meant to be dealt in is realised within a short time after acquisition. But there are many exceptions from this as a universal rule;
3. THE FREQUENCY OF SIMILAR TRANSACTION.
If realisations of the same sort of property occur in succession over a period of years or there are several such realisations at about the same date a presumption arises that there has been dealing in respect of each;
4. SUPPLEMENTARY WORK.
If the property is worked on in any way during the ownership so as to bring it into a more marketable condition, or if any special exertions are made to find or attract purchasers, such as the opening of an office or large-scale advertising, there is some evidence of dealing. When there is an organised effort to obtain profit there is a source of taxable income. But if nothing at all is done, the suggestion tends the other way;
5. THE CIRCUMSTANCES THAT WERE RESPONSIBLE FOR THE REALISATION.
There may be some explanation, such as a sudden emergency or opportunity calling for ready money that negates the idea that any plan of dealing prompted the original purchase;
There are cases in which the purpose of the transaction and sale is clearly discernible. Motive is never irrelevant in any of these cases and can be inferred from surrounding circumstances in the absence of direct evidence of the seller’s intentions.
Say an individual is employed in an investments role by day and makes considerable CFD profits in his/her spare time based on a significant number of transactions, how would this income be taxed?
Although opinions published by Revenue in the context of financial services are primarily concerned with group financing and treasury operations I believe they have direct relevance to this situation and should certainly be taken into consideration in ruling in favour of Income Tax Treatment.
In one such case, Revenue believed that the company was trading on the basis that the company was actively managing the business and making strategic decisions regarding financing and treasury operations. Despite the fact that the activities of the company were outsourced (i.e. no individuals were employed in the company), the outsourcing arrangement was managed and controlled by Irish resident directors with the appropriate level of specialized expertise in this area.
In this example, as the individual’s Irish PAYE employment relates to the area of financial services/investments, it would be difficult to see how Revenue could treat his/her C.F.D. activities as anything other than trading activities liable to Income Tax.
In summary, as the C.F.D. relates to a large number of transactions with a profit motive which requires a considerable amount of skill and expertise, it would be highly probable that this income would be liable to Income Tax and not Capital Gains Tax.