Tax treatment of compensation and insurance
Written by Ray Coman
In broad principal, compensation is subject to tax to the extent that the thing being compensated for is subject to tax. In the majority of straightforward cases, the rule is that if no tax relief was obtained on the insurance premium, no tax is payable on the insurance proceeds. The tax treatment of different types of compensation and insurance are explained in the sections below.
Insurance paid for from take home pay, will typically not be taxable. Examples include holiday and mortgage payment insurance. Most household contents are “chattels” and therefore exempt. It is only items worth over £6,000 and expected to last over 50 years that are likely to give rise to tax when damaged or destroyed.
Personhood is not taxable. Accordingly, compensation to remedy personal injury, distress or loss of reputation is generally exempt.
The following types of insurance are examined in separate reports within this section:
Health insurance which pays for medical treatments.
Critical illness, pays a lump sum if the person become seriously ill.
Income protection covers long term or permanent inability to return to work due to sickness of accident.
Life assurance pays to beneficiaries on death of the policyholder.
The inheritance tax implications are life insurance are explored.
The first £30,000 of compensation is exempt for unfair dismissal or redundancy. Section 401 ITEPA 200. Thereafter it is taxable. Where termination pay is specified by employment contract it is not regarded as compensatory.
Compensation is dealt with under the capital gains tax regime to the extent that it derives from a capital asset. Compensation is taxable to extent that tax is payable on the underlying asset. Section 22 CGTA 1992.
A home is not taxable if it is a principal private residence. Most building insurance benefits are not taxed. However, compensation paid for damage or destruction to a building which is not a home is a taxable benefit. If the property is let, buildings insurance premiums are deducted from tax adjusted rental profits.
A different article more fully covers capital gains tax implications for loss or damage of physical assets such as: investment property, art and antiques.
The rules that attach compensation to the asset captures any loss or disadvantage in connection with the property. This includes for instance revocation of planning permission. The fact that damages are computed by reference to loss of income is disregarded. Where the compensation is identified as relating to the asset, it is subject to capital gains tax.
A car is exempt from capital gains tax. Motor insurance payments are therefore not taxable.
Damages for professional negligence claims are exempt inasmuch as the payment does not relate to an underlying asset. Although, HMRC have said that it will review the tax treatment of compensation which exceeds £500,000. Money received from a Payment Protection Insurance (PPI) claim is not taxable.
Compensation for injury to feelings, inconvenience or distress is taxable to the extent that it is connected to the underlying asset (for capital gains) or office of employment (for earnings). It is not taxable to the extent that it relates to a person.
For instance, if ‘hurt feelings’ result from termination of employment, only the first £30,000 of that award is taxable. By contrast hurt feelings resulting from discrimination unrelated to termination of office are not taxable. The principal is that the compensation is not related to loss of income but to a form of personal injury.
This covers for the cost of compensating a client who seeks damages for advice or service which has resulted in loss of money. The cost of cover is deducted from tax.
Once a person retires or otherwise disposes of their business, run off insurance is used to cover any subsequent claims. A professional usually requires run off cover for a two-year post cessation period. A provision in the final set of accounts allows this type of cover to be treated as tax deductible.
Products are available to cover business loss resulting from fire, flood or theft. Premiums can be deducted from profits in the calculation of tax. The benefits are taxable. The cost of stock, rent, salaries for key employees and other overheads can be deducted from tax adjusted profits. Repairs to equipment and property are an allowable expense for tax purposes. Where the contents have been lost, destroyed or stolen, the cost of replacement will mostly be covered by capital allowances. For buildings and land come under the capital gains tax regime. Useful in this context is the guidance on capital gains tax on receipt of compensation.