Damages & Tax
Tax in Damages Calculation
At common law, awards of damages were not reduced or adjusted on the basis of the taxation effect. The issue of taxation arises in relation to a loss for which damages are awarded, which would otherwise be subject to tax, but where the damages awarded are not themselves subject to tax.
In a famous case in 1956, the House of Lords held, in relation to a personal injuries claim. that past and future loss of earnings must take account of the taxation of income. In this case, the damages themselves were not subject to tax, so the failure to take account of tax would overcompensate.
It is necessary to consider the amount of loss which would have been otherwise taxed and the extent to which the damages are not taxed. Whether or not the damages are taxable depends on the application of tax law. This will involve consideration of the type of loss concerned.
Tax on Award
Capital gains tax may be relevant in relation to loss arising from the destruction of an asset. Generally, damages which represent the proceeds of the destruction of an asset are subject to CGT. Rollover relief may be available.
Capital gains tax legislation exempts sums arising from personal injuries and certain other sums from the charge to capital gains tax.
Many types of damages will not be taxable at all. Damages for personal injuries received as a lump sum (in the usual way) are not generally taxable. Income earned on the capital/lump sum is taxable in the same manner as interest generally.Some exemptions exist.
Sums for non-pecuniary loss are not generally subject to taxation. Loss of amenity, bodily injury, pain and suffering are not subject to taxation. In contrast, earnings will generally be subject to taxation.
Damages may be subject to tax, but to less tax than would have applied to the income or monetary loss concerned.
Effect of Tax
Courts have been reluctant to go into a detailed analysis of the extent to which one factor offsets the other. The English courts have taken the view that if the damages are taxable, the court need not inquire further. Other courts have criticised this view as arbitrary and required that a more detailed analysis be undertaken.
In some cases, anomalies may arise. Awards on termination of employment used to enjoy substantial exemptions from taxation in recognition of the particular difficulties an individual may encounter on termination of employment. The extent of income exempted has been limited significantly
Damages may be subject to tax than on the underlying loss. On this basis, damages should be increased to take into account this factor. This may occur where the lump sum is taxable because it is received all at once, whereas the income might have been spread over a greater period at lower rates and with greater offsetting allowances.
Modern Approach
The modern view is that full account is taken of the taxation differential. The calculation may be complicated.
The principle is applicable across the board from personal injuries, claims for defamation, unfair dismissal, breach of contract trespass, damage to goods etc. In each case, it is necessary to consider the matter from the perspective of the above principle.
The onus is on the defendant to show that on the facts alleged, the damages would be taxable. The onus is on the claimant to prove the particulars of his loss in terms of the incidence of taxation.
It appears that mathematical exactness is not required. The parties’ tax experts should be able to agree or ascertain the figures. Evidence may be offered if the advisors do not agree. It appears that the impact of taxation is considered at the current prevailing tax rates. Past rates are relevant in relation to pre-trial loss.
Ireland
The Irish Supreme Court has confirmed the principle that the effect of tax should be taken into account in awards of damages, where the failure to make the appropriate adjustment in assessing the damages would result in a windfall for the claimant. The Irish courts have also held that where damages for loss of profits are themselves taxable, no deduction should be made.
The principle applies to claims for loss of profit. Profits are generally taxable, whereas the receipt of a lump sum may be subject to capital gains tax or may be exempt. Evidence should be given as to the actual loss incurred.