Your business premises has been damaged by a building contractor. He’s agreed pay you compensation to avoid the hassle. Will the payment count as taxable income for your business?
Compensation payments
For many years HMRC’s approach to compensation payments was somewhat mixed, with contrasting approaches being taken by different tax inspectors. These days there’s a consistent policy which depends on what the compensation relates to. The starting point is to identify whether the amount received as compensation relates to an asset, say a building, or not.
Asset-linked compensation
Where you’re paid compensation because the value of one of your assets has reduced due to the action of someone or something else, HMRC treats it as if you disposed of (sold or transferred) a part of the asset in exchange for the payment.
Example 1. Acom Ltd received a payment from Bloggs and Co to compensate it for the permanent restriction to Acom’s access to its premises. The effect of the restriction was to reduce the value of Acom’s property. The tax position treats the compensation as if Acom had sold part of its rights to the property. This type of transaction is subject to capital gains tax (CGT).
Example 2. Acom’s premises is physically damaged by someone else’s actions. They pay Acom compensation. This also counts as if Acom had made a sale of part of its property and therefore the compensation is liable to CGT.
Company or unincorporated
The tax effect for your business depends on whether it’s run through a limited company or is unincorporated, i.e. a partnership or sole trader.
Tip. Business partners and sole traders can use their annual exemptions (£12,300 for 2021/22 and 2022/23) to reduce the amount of tax payable on a compensation payment which is liable to CGT. Companies have no annual exemption but can reduce the amount of capital gain to cancel out the effects of inflation over the period they owned the asset (the indexation allowance), but only up to 31 December 2017.
Working out the tax
The good news is that apart from the exemption and allowance mentioned above you can reduce the amount on which you’ll pay CGT further by knocking off part of what the asset cost you. You work out this amount using the standard CGT formula for part disposals of assets, i.e. A/A+B x cost, where A is the amount you received and B is the value of the asset after the “disposal”.
Example 3. Using the facts in example 1 above, the amount paid to Acom was £15,000. It paid £180,000 for the property in 2010 and after the access was restricted it was valued at £260,000. Applying the formula (£15,000/£15,000 + £260,000 x £180,000) gives £9,818. So Acom can deduct £9,818 and the indexation allowance on that amount – roughly £6,000 – from the £15,000. This produces a negative figure and so Acom has no tax to pay.
Note. Because Acom deducted £9,818 of the cost of the property it can’t deduct that amount when working out if it has CGT to pay when it sells the property, i.e. it can only deduct £170,182 (£180,000 – £9,818).