Tax Journal by Mark McLaughlin ATII TEPWhat are the tax implications if a business receives compensation or damages for the cancellation, breach or variation of a trading agreement? This article considers the position.The Schedule E tax treatment of compensation payments by employers upon termination of an employee’s contract of employment is potentially fairly complex, and much has therefore been written on the subject. But what of the tax implications for a business if a customer pays it compensation upon terminating a trade agreement, such as a manufacturer paying an agent compensation for the early termination of an agency agreement? Is the tax treatment any more straightforward? This article deals with the tax position where a business receives compensation or damages for the cancellation, breach or variation of a trading agreement.
Taxable or not?
The tax legislation offers little assistance in answering the question whether and to what extent business compensation or damages receipts are taxable. This has resulted in a number of cases decided through the courts. For a receipt to be treated as trading income, it must be a profit or gain arising in respect of the business (ICTA 1988, s 18). On the other hand, a chargeable gain can arise on the disposal of assets (TCGA 1992, s 1) and on capital sums derived from assets, such as compensation for the loss of an asset (TCGA 1992 s 22(1)). A charge to income tax generally takes precedence over a capital gains tax charge (TCGA 1992, s 37). Therefore, the first question to ask is whether the compensation is a receipt of the trade. If it is, the possibility of a capital gains tax liability does not arise.
There is a specific exemption from capital gains tax in respect of compensation or damages for wrong or injury suffered by an individual (but not a company) in his person, profession or vocation (TCGA 1992, s 51(2)). ‘Wrong or injury’ includes breaches of contractual duties, and the exemption covers receipts of damages for professional negligence in respect of the wrong or injury. In those circumstances, there is no underlying asset. However, a breach of contract results in a right of action, which is an asset if it can be the subject of an award or a negotiated settlement involving the payment of compensation or damages.
So on the basis of the legislation alone, a compensation payment could be business income or a capital receipt. Little wonder that there is ample case law on the subject!
Income or Capital?
For a receipt to be treated as trading income, it must be a profit ‘arising from’ the trade. For example, compensation paid by a manufacturer for the early termination of an agreement with an agent is clearly referable to the trade. But if the receipt is intended to compensate the agent for loss of profits, is it trading income? If a business is an agent for a number of manufacturers and the compensation relates to only one contract, the receipt is likely to be trading income if the agency can continue its business as before. In Kelsall v Parsons ( 21 TC 608), a business acting as agent for a number of manufacturers received compensation for the early termination of one of its agency agreements, which was held to form part of taxable profits.
More recently, in Consultant v Inspector of Taxes ( SSCD 63), compensation for the termination of a consultancy agreement by mutual consent was held to be revenue in nature, as it did not affect the whole structure of the taxpayer's profit making apparatus. The taxpayer could still operate in the same industry and in other business activities.
In some cases, a single trading agreement may form the whole or a substantial part of the business. The loss of an agreement might be such that the business is unable to continue, or is fundamentally affected. This can have the effect of altering the nature of the receipt from income to capital. In Van den Berghs Ltd v Clark ( 19 TC 390), a company entered into trade ‘pooling’ agreements with a Dutch competitor. Following a dispute over amounts due to the company, the Dutch competitor paid £450,000 as damages for the cancellation of the company’s future rights under the agreements, which still had a number of years left to run. The House of Lords held that this payment was a capital receipt of the company. In his judgement, Lord Macmillan distinguished those agreements from ordinary commercial contracts made in the course of carrying on a trade. He said:
‘…the cancelled agreements related to the whole structure of the Appellants’ profit-making apparatus. They regulated the Appellants’ activities, defined what they might and might not do, and affected the whole conduct of their business.’
‘The agreements formed the fixed framework within which their circulating capital operated; they were not incidental to the working of their profit-making machine but were essential parts of the mechanism itself. They provided the means of making profits, but they themselves did not yield profits. The profits of the Appellants arose from manufacturing and dealing in margarine.’
In general, compensation received by businesses upon termination of an ordinary trading contract is likely to be treated as a revenue receipt, where there are a number of separate contracts with other customers. However, the decisions in Van Den Berghs and subsequent cases have established an important exception to this rule. If the contract relates to one contract which is so dominant that its loss accounts for substantially the whole of the trade, or the contract regulates the whole structure or framework of the trade, the receipt may be capital in nature, although in the Revenue’s view it should be ‘exceptionally’ treated in this way (see the Inspector’s Manual at para 364).
Aside from the cancellation of contracts, the variation of a trading agreement can also adversely affect the whole profit making structure of a business. In Sabine v Lookers Ltd ((1958) 38 TC 120), a motor dealing company received compensation from a motor manufacturer for any loss resulting from alterations made to an agreement between them. This payment was held to be a capital receipt, on the basis that the variation weakened the whole of the company’s profit making structure.
Substantially the whole?
The exception in Van Den Berghs raises a further question. The Inspector’s Manual at paragraph 364 indicates that ‘substantially the whole’ of the trade must be affected. But what does this phrase mean? Perhaps unsurprisingly, no formal definition is given in this particular context, either in statute or by Revenue interpretation, and it is therefore necessary to look again to case law for assistance. For example, in CIR v Fleming & Co (Machinery) Ltd ( 33 TC 57), a compensation agreement that accounted for between 30% and 45% of the company’s earnings was held to be a trading receipt. Subsequently, in Fleming (HM Inspector of Taxes) v Bellow Machine Co Ltd ( 42 TC 308), payments received for the grant of a sub-agency out of an agency that accounted for 60% to 86% of the company’s total agency business were held to be trading receipts.
However, in Barr, Crombie & Co v CIR ( 26 TC 406), the Appellant company managed ships under agreements with a shipping company that went into liquidation at a time when an agreement still had about eight years to run. For most of the periods covered by agreements between the companies, only 2% of the Appellant company’s business was derived from other ship management, and on liquidation of the shipping company it lost all such business except for certain temporary wartime ship management. Compensation received from the liquidated company for the remaining period of the agreement in those circumstances was held to be a capital receipt.
Rights of action
If compensation is deemed to be a capital receipt, is there a chargeable gain potentially? As stated earlier in this article, in order for a capital receipt to be a chargeable gain, it must be received in respect of an asset. In O’Brien v Benson’s Hosiery (Holdings) Ltd ( STC 735), a company director paid the company £50,000 to be released from his future obligations under a service contract. The House of Lords held that the company’s receipt was taxable as a chargeable gain, on the basis that its contractual right as an employer was an asset which had been turned to account. Note that it was a right and not the contract itself which gave rise to the gain. A right is derived from the contract, and the capital sum is derived from the right.
In the context of compensation and damages, a right of legal action is a separate asset for capital gains tax purposes, which is to be distinguished from a contractual right, such as the right of service in the O’Brien case, or the right of a business to act as agent for a manufacturer.
In Zim Properties Ltd v Proctor ( STC 90), the company contracted to sell some of its properties, but because it was unable to show good title to one of them the contract was repudiated. The company believed that this repudiation was caused by the negligence of the solicitors acting in the transaction, and commenced legal action against them. The Court held that the company’s right to sue the solicitors constituted an asset for capital gains tax purposes. The company was therefore liable to corporation tax on the chargeable gain on the out-of-court settlement derived from that right of action (TCGA 1992 s 22(1)(c)).
The distinction between a contractual right and the right of action for damages (as in the Zim Properties case) is important, because concessionary treatment (Concession D33) potentially applies to the latter category. Concession D33 was published following the decision in Zim Properties, and broadly states that damages or compensation payments can be treated as derived from an underlying asset if there is one. Hence the receipt is exempt if the underlying asset is exempt (e.g. an individual’s principal private residence), or can be subject to relief from capital gains tax in appropriate cases (e.g. where the underlying asset qualifies for rollover relief). If a right of action is not derived from any underlying asset (e.g. negligent advice from a tax adviser), any gain accruing from the disposal of the right of action is exempt by concession.
In determining whether compensation or damages for the variation, breach or termination of a trading agreement is a taxable business receipt, it is necessary to consider whether the loss to the recipient business represents substantially the whole of its trade, or whether the agreement regulates the whole structure and conduct of that business. If the business is able to continue largely unaffected, the compensation payment is likely to be a trading receipt. If not, then any sum derived from a right of action arising from a breach of the agreement is likely to be a capital receipt instead.