Taxation by Mark McLaughlin ATII TEPThe tax implications of damages for personal injury are described by Mark McLaughlin ATII ATT TEP.WE LIVE IN interesting times. We also live in an increasingly litigious world. This may be good news or bad news, depending on whether you are a litigation lawyer or forensic accountant on the one hand or, for example, a sole practitioner struggling to come to terms with an increasing annual professional indemnity insurance premium on the other. It therefore seems an opportune time to consider how damages for personal injury are treated for tax purposes. All references are to the Taxes Act 1988 unless otherwise stated.
Before considering the tax treatment of damages for personal injury, it is worth considering what ‘personal injury’ actually means. The statutory definition for income tax purposes states that it includes ‘any disease and any impairment of a person’s physical or mental condition’ in the context of personal injury damages annuities, more commonly described as ‘structured settlements’ (section 329AA(5)). The same definition applies to ‘personal injuries’ (plural) in respect of interest on damages (Section 329(4)).
For capital gains tax purposes, there is a complete exemption for ‘compensation or damages for any wrong or injury suffered by an individual in his person or in his profession or vocation’ (section 51(2), Taxation of Chargeable Gains Act 1992). The Revenue considers that ‘in his person’ has a wide definition extending beyond physical injury, so that damages or compensation for ‘distress, embarrassment, loss of reputation or dignity’ such as unfair discrimination are not chargeable. The same exemption applies to wrong or injury suffered in a professional capacity, such as libel or defamation (Capital Gains Manual at paragraphs 13030 to 13032).
Damages for personal injury often fall into two categories. The first is an element for pain and suffering and this is never liable to income tax in the hands of the recipient.
The second element is usually for loss of present or future earnings. Although there is no statutory relief or direct authority on the point, it appears to be accepted that this element is also not liable to income tax. The point is not referred to in the Revenue manuals, but it is believed nevertheless that the Revenue accepts the proposition that compensation for lost earnings is not liable to income tax where the claim results from personal injury sustained by a trader or employee. Thus if a trader is off work as a result of a road accident where another party was at fault, the claim for damages should not be liable to income tax upon receipt. However, see below concerning the Gourley case.
Damages as capital sums
The capital gains tax exemption for damages and compensation is an important exception to the general rule established in Zim Properties Ltd v Procter  STC 90, that the right to take action for compensation or damages is a chargeable asset within section 22(1)(a), Chargeable Gains Tax Act 1992, and that compensation or damages received by court order or negotiated settlement arises from the disposal of that right of action. The Zim case resulted in Revenue Extra-statutory Concession D33, which states that the capital gains tax exemption also applies to professional negligence compensation for a failed action for wrong or injury, if amounts to be received under the original action would have been exempt.
Compensation received by relatives and others in respect of a deceased personal injury victim or emotional distress caused by another person’s death is similarly exempt, although the exemption only applies to ‘wrong’ or ‘injury’ suffered by individuals, not companies (paragraph 12 of Concession D33).
The prospect of receiving a non-taxable capital sum as damages for personal injury may seem attractive initially. However, it should be remembered that in calculating a loss of income by the claimant, the incidence of hypothetical tax on any actual and prospective loss of earnings, etc. must normally be taken into account. Damages are therefore assessed on the basis of the net loss after tax. This rule of law (the ‘Gourley principle’) follows the House of Lords’ decision in British Transport Commission v Gourley  AC 185. Note that the Gourley principle applies only where two conditions are satisfied: (i) that the lost income would have been taxable if received in the normal way, and (ii) that the damages to be received will not themselves be taxable. The second condition often gives rise to dispute between the parties. The two conditions have not been applied in Scotland.
Interest on damages
Interest included in damages for which a High Court or County Court judgment is given (or under certain other provisions in section 329(2)) is exempt from income tax. This exemption is extended to payments into court, and also out-of-court settlements, if the interest would otherwise have been exempt had it been included in a judgment. If damages are awarded by judgment, the actual date of that judgment will be significant where, for example, there is any delay in the payment of damages and interest arises both pre and post-judgment, as interest in the latter case is taxable. If the parties settle out of court, it should be noted that the legislation appears to set the exemption cut-off point at the date of payment, not the date of judgment (section 329(3)).
By concession, interest on damages for personal injury awarded by a foreign court is treated as exempt in corresponding circumstances, provided the interest is exempt in the country where the award is made (Concession A30).
In personal injury cases, a structured settlement is an alternative to a conventional lump sum damages award, particularly in cases where considerable sums are involved, such as medical negligence or road traffic accident cases. A structured settlement is broadly an arrangement whereby the defendant (or more likely his insurer) agrees to make regular payments to the claimant over the life of the injured person, typically in addition to a lump sum to meet immediate or special needs such as nursing care. The regular payments are normally funded through the purchase of an annuity from a life insurance company, although amounts can be paid directly by the defendant, such as health authorities in medical negligence claims.
Structured settlements (or ‘periodical payments’ as the legislation actually refers to them) have an unusual tax history, because they existed for some time before the introduction of any rules dealing with their tax treatment. There was a substantial delay between the implementation of the first structured settlement in the late 1980s (approved in Kelly v Dawes, Times Law Reports, 27 September 1990), and the introduction of legislation in Finance Act 1995. In the interim period, standard agreements approved by the Revenue allowed structured settlements to facilitate tax-free periodical payments. Subsequent legislative provisions initially allowed an annuity purchased under a ‘qualifying agreement’ to be excluded from an income tax charge in the annuitant’s hands. Structured settlements were made more flexible by Finance Act 1996 for payments after 29 April 1996, by virtue of section 329AA, Taxes Act 1988. Consequently, court awards or agreed amounts in respect of personal injury damages consisting wholly or partly of periodical payments are not regarded as income for income tax purposes of the following parties:
• the claimant;
• any person receiving the payments on the claimant’s behalf, such as a family member; or
• trustees receiving the payments on trust for the claimant as sole lifetime beneficiary.
Distributions to or for the beneficiary out of the structured settlement annuity do not constitute taxable income.
The same tax exemption applies to interim court awards or payments by the defendant, and to awards made under the Criminal Injuries Compensation Scheme (section 329AB). The life office or defendant responsible for paying the annuity does so without deduction of income tax.
Structured settlement annuities can be payable for a guaranteed period, in case the personal injury victim dies prematurely. Payments made after death are taxable, although the Revenue characterises them as a purchased life annuity with an exempt capital element. However, annuities paid other than by a life office after death are treated as wholly capital, as the Revenue appears to accept that such payments ‘… will not become chargeable to tax following the death of the victim’ (Assessment Procedures Manual at paragraph 993). The Revenue also accepts that there is no geographical restriction to the exemption from tax in respect of structured settlement annuities received from a foreign territory.
In some cases of damages for personal injury, possibly involving accidents or negligence resulting in disability, the claimant may be in receipt of means tested state benefits, such as Income Support. Payments of income from a structured settlement (being an ‘annuity’) purchased with funds derived from personal injury damages awarded to the claimant are disregarded in their entirety when used for items other than everyday living expenses (e.g. food, heat and light, ordinary clothing or footwear). If the payments are used for such expenses, the first £20 per week is disregarded for the purposes of Income Support and certain other benefits (The Income Support (General) Regulations, SI 1987/1967, paragraph 15(5A)(d) of Schedule 9).
Personal injury trusts
A trust may also be created from personal injury damages with a view to retaining entitlement to state benefits, in which the claimant is a beneficiary. Payments of income from trusts whose funds are derived from personal injury damages are disregarded for Income Support purposes when used for items other than everyday living expenses (The Income Support (General) Regulations, SI 1987/1967, paragraph 15(5A)(c) of Schedule 9). Any form of trust (e.g. bare, life interest or discretionary) would appear to be acceptable for these purposes.
Capital is also disregarded for Income Support purposes, if the funds are derived from a payment made in consequence of personal injury to the claimant (The Income Support (General) Regulations, SI 1987/1967, Regulation 46, paragraph 12 of Schedule 10). The recipient may therefore wish to settle those damages on trust for state benefit purposes. There are ‘notional capital’ anti-avoidance rules dealing with capital deprivation to enhance Income Support entitlement, but there is an exception to those rules for funds held in trust derived from damages for personal injury (Regulation 51(1)(a)).
There is generally no distinction between the tax treatment of personal injury trusts and other categories of trust, except that trusts for disabled persons that meet certain statutory conditions are afforded ‘tax favoured’ status.
Capital gains tax
For capital gains tax purposes, the trustees of a settlement are generally entitled to half the annual exemption for individuals. Settlements made after 6 June 1978 by the same settlor (other than ‘excluded settlements’, broadly non–resident, charitable or certain retirement benefits scheme trusts) are restricted to an exemption equivalent to the greater of half the annual exemption divided by the number of such settlements, and one–tenth of the exempt amount for individuals.
However, the ‘full’ annual exemption is available to the trustees of a settlement for a ‘mentally disabled person’ (as defined), or a physically disabled person in receipt of certain state benefits. The terms of the trust must satisfy qualifying conditions as to securing the application of settled property and entitlement to income during the lifetime of the disabled beneficiary (paragraph 2 of Schedule 1 to the Taxation of Chargeable Gains Act 1992).
The benefit of the additional exemption should perhaps be kept in context. For 2003-04, the maximum tax saving is only £1,343 (i.e. the full annual exemption of £7,900 less the maximum exemption for a non-qualifying trust of £3,950, multiplied by 34 per cent).
A discretionary trust for ‘disabled persons’ receives special inheritance tax treatment compared to ‘ordinary’ discretionary trusts if certain conditions are satisfied, such as to there being no interest in possession of settled property during the disabled beneficiary’s lifetime, and as to the settlement securing that at least 50 per cent of property which is applied being used for the beneficiary’s benefit (section 89, Inheritance Tax Act 1984).
For example, a lifetime transfer by the disabled person is effectively treated as though the property remains in the settlor’s estate. A lifetime transfer into trust for a disabled person by someone else is normally treated as a potentially exempt transfer, although exemption from inheritance tax is available if the gift is for the maintenance of a family member satisfying the conditions in section 11, Inheritance Tax Act 1984. There is also no inheritance tax charge on ten-yearly anniversaries of the trust, and no exit charge on capital distributions to the disabled beneficiary.
Whilst the question whether there are better alternatives for settlements of personal injury damages than a trust for disabled persons for inheritance tax purposes is outside the scope of this article, it should be noted that it is not possible to ‘opt out’ of the inheritance tax treatment afforded by section 89, Inheritance Tax Act 1984 where the relevant conditions are satisfied. The rules may need to be deliberately broken in appropriate cases.
Prevention or cure?
The subject of damages for personal injury is wide and varied, possibly encompassing state benefit and other issues. However, an excursion into the tax rules alone brings to mind the old adage ‘prevention is better than cure’!