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:
- Personal Injury
- Compensation for Revenue Loss
- Compensation for Capital Loss
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:
- The compensation must be for personal injury.
- It must have been received arising from the institution of a civil action for damages in the court (where such an action is initiated but settled out of court, the compensation will still qualify) or pursuant to the issue of an order to pay under Section 38 of the Personal Injuries Assessment Board Act 2003.
- Payments awarded by the Criminal Injuries Compensation Tribunal also qualify.
- The person receiving the compensation, must, as a result of the injury, be permanently and totally incapacitated, either physically or mentally, from maintaining himself/herself.
- The income obtained from the investment of the compensation must be the individual’s sole/main income.
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:
- Compensation under an insurance policy for the destruction of trading stock, accidents to members of staff or loss of profits.
- Losses arising as a result of a breach of contract, etc.
3. Compensation for Capital Losses
The main examples under this heading are as follows:
- Compensation for damage or loss of an asset including land, buildings, plant, machinery, etc.
- Insurance payments as a result of loss, damage, depreciation or destruction of an asset.
- Compensation for the surrender or forfeiture of rights.
- Compensation for the exploitation or use of an asset.
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:
- An individual aged in his sixties received a considerable payment through the Irish courts.
- It was held to be compensation as a result of a satisfactory settlement of a case for breach of a joint venture agreement.
- The settlement was deemed to be compensation of a capital nature and therefore liable to taxation under the Capital Gains Tax legislation.
- The reason it was to be taxed in this manner was because the payment represented damages for breaching a joint venture agreement which related to the entire structure of the company’s profit making apparatus as in Van den Berghs Ltd. v Clark (1935) 19 TC 390.
- The individual had been a director of a family company with a shareholding of 30% who retired from the company some years earlier and had disposed of his full shareholding to the other directors.
- When he sold his shares, the entire proceeds were exempt from Capital Gains Tax under Section 598 of the Taxes Consolidation Act 1997.
- The reason he was exempt from Capital Gains Tax on the proceeds of the sale of his shares was because he qualified for “Retirement Relief.”
- To be eligible for Retirement Relief the following conditions must be met: (a) The individual must be over 55 years, (b) He/She must have been a Director for at least ten years prior to the date of the disposal, (c) He/she must have been a full time working Director for at least five of those last ten years years, (d) He/She must have held “qualifying” shares (i.e. he/she must have owned shares in the company for more than ten years, (e) it must have been a family company (the individual must have held at least 25% of the voting rights or at least 10% of the voting rights with not less than 75% being controlled by family members), (f) it must have been a trading, farming or holding company of a trading group and (g) the proceeds relating to the qualifying assets must not have exceeded €750,000.
- The compensation payment received by the individual was also deemed to qualify for Retirement Relief under Section 598.
- At the time the individual disposed of his 30% shareholding to the other directors of the family company, the price he received was well below market value.
- The individual accepted this consideration, which was well below the threshold amount of €750,000, on the written agreement that if the company was successful in their claim for damages for breach of a joint venture agreement, that he would receive 30% of the compensation.
- It held that the individual’s 30% share of the compensation awarded was eligible for Retirement Relief (since he met all the conditions of Section 598 TCA 1997) as it related to the disposal of “qualifying assets,” being his 30% shareholding, some years earlier.