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Taxation by Mark McLaughlin ATII TEP

The direct tax treatment of business compensation receipts is considered by Mark McLaughlin ATII ATT TEP.Business relationships are sometimes compared with marriages. Without wishing the reader to infer too much into the writer’s private life, if this is an accurate analogy I fear for the future welfare of businesses generally! Like marriages, business relationships experience ‘ups’ and ‘downs’, and sometimes a parting of the ways. This article considers the tax implications when a business receives compensation or damages for the cancellation of a trading contract, such as a manufacturer paying compensation for the early termination of an agency agreement.

Income or capital?

A receipt of business compensation or damages may be treated as income or capital, depending on the circumstances. This distinction may be important for a number of reasons. For example, losses brought forward may be available to relieve a trading profit attributable to a receipt treated as revenue income. Alternatively, a capital receipt may be eligible for relief from capital gains tax, e.g. taper relief, or corporation tax on chargeable gains, e.g. rollover relief.

For a receipt to be treated as income, it must be a profit arising ‘in respect of’ the trade, profession or vocation (section 18(3), Taxes Act 1988). For example, compensation paid by a manufacturer for the early termination of an agreement with an agent is clearly referable to the trade. The same treatment can apply to the breach or variation of an agreement. This point was explained clearly by Lord Justice Diplock in London and Thames Haven Oil v Attwooll 43 TC 491:

‘Where, pursuant to a legal right, a trader receives from another person compensation for the trader’s failure to receive a sum of money which, if it had been received, would have been credited to the amount of profits (if any) arising in any year from the trade carried on by him at the time when the compensation is so received, the compensation is to be treated for income tax purposes in the same way as that sum of money would have been treated if it had been received instead of compensation. The rule is applicable whatever the source of the legal right to recover the compensation.’

On the other hand, compensation may be a receipt of the trade, but derived from the loss of an asset, such as goodwill (section 22(1), Taxation of Chargeable Gains Act 1992). This begs the question, how does one distinguish compensation for loss of profits between income and capital? Unfortunately, statute offers little assistance in finding the answer. This has resulted in substantial litigation over the years, helping to establish the following principles:

- If a business has agency agreements with a number of manufacturers, and the compensation relates to only one contract, the receipt is likely to be trading income if the business is largely unaffected, and the trade can therefore continue as before (Kelsall Parsons & Co v Commissioners of Inland Revenue 27 TC 167).
- A single trading agreement may form the whole or a substantial part of the business. If the loss of a contract jeopardises or fundamentally affects the business, the nature of the receipt may be capital. The cancelled agreement must relate to the whole structure of the business profit-making apparatus (Van den Berghs Ltd v Clark 19 TC 390). The variation of trading agreements can also give rise to a capital receipt, if those variations weaken the whole structure of the trade (Sabine v Lookers Ltd 38 TC 120).

In practice, compensation receipts will often not fall squarely within these two circumstances. For example, compensation for the termination of a single consultancy agreement representing the whole profit-making structure of an individual’s consultancy business can still be taxable income, if the ‘business’ is the consultant, and the termination of an agreement is unlikely to prevent that individual operating in the same and other business activities (A Consultant v Commissioners of Inland Revenue [1999] STC (SCD) 63).

However, the general principle remains that if the cancellation, variation or breach of a trading agreement either destroys or materially affects the recipient’s profit-making structure and character, compensation or damages may be capital in nature. The issue then is where the line is drawn between income and capital.

The dividing line

In the Van den Berghs case, a company entered into trade ‘pooling’ agreements with a Dutch competitor. Following a dispute over amounts due to the company, the Dutch business paid a sum of 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 the receipt was capital. The judgment by Lord Macmillan distinguished the cancelled agreements from ordinary commercial contracts made in the course of carrying on a trade:

‘… the cancelled agreements related to the whole structure of the appellants’ profit-making apparatus. They regulated the appellants’ activities, defined what they might and what they might not do, and affected the whole conduct of their business. I have difficulty in seeing how money laid out to secure, or money received for the cancellation of, so fundamental an organisation of a trader’s activities can be regarded as an income disbursement or an income receipt.’

How is compensation in respect of contracts which are less than ‘fundamental’ to the trader’s activities to be treated? The Revenue’s view is that for capital treatment to apply, the compensation must refer to ‘one contract which is so dominant that its loss accounts for substantially the whole’ of the trade (Inspector’s Manual at paragraph 364). ‘Substantial’ is not defined in this context. However, case law relevant to compensation for the cancellation of business contracts provides some guidelines:

- Compensation relating to the loss of an agency, from which a ship managers’ business derived 88 per cent of its trade receipts (two per cent being derived from other managements, and ten per cent representing non-management income) was held to be capital in Barr, Crombie & Co Ltd v Commissioners of Inland Revenue 26 TC 406.

- A company with sole United Kingdom distribution rights for a German manufacturer representing 60 to 86 per cent of the company’s total agency business received sums for the grant of a sub-agency, which were held to be trading receipts in Fleming v Bellow Machine Co Ltd [1965] 42 TC 308.

More recently, as pointed out in Malcolm Gunn’s article ‘All Very Unsettling’ (Taxation, 13 March 2003 at page 575), the Revenue interprets ‘substantially’ in tax legislation as 75 per cent or more for certain purposes. Additionally, for capital gains purposes, substantial can mean 80 per cent or more. The numerical test in the exemption for disposals by companies with substantial shareholdings is only ten per cent, but this use of the word ‘substantial’ is specifically applied only for the purpose of deciding whether a company holds a substantial shareholding in another company (see Revenue Interpretation 247).

It therefore seems likely that the compensation would need to relate to the loss of 80 per cent or more of the trader’s business for the receipt to be considered capital in nature, although the Revenue would no doubt prefer to exercise its own judgment on an individual basis.

Capital treatment

Before the introduction of capital gains tax in 1965, taxpayers would generally contend that compensation receipts represented non-taxable capital. This helps to explain the number of ‘old’ cases on this subject. Nowadays, if the compensation receipt is capital in nature, liability to tax can arise on a chargeable gain.

In O’Brien v Benson’s Hosiery (Holdings) Ltd [1979] 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 receipt was taxable as a chargeable gain in the company’s hands, on the basis that its contractual right as an employer was an asset which had been turned to account.

Zim Properties v Proctor [1985] STC 90 subsequently established the principle that a right of court action is an asset for capital gains tax purposes. The Zim decision resulted (a few years or so later) in the Revenue issuing Extra-statutory Concession D33 concerning compensation and damages. By concession, if a right of action relates to an underlying asset, for example a building in the case of an action against an estate agent for negligent advice in respect of a sale, a compensation receipt can be treated as proceeds for the disposal, or part-disposal, of that asset. The base cost of the underlying asset, or 31 March 1982 value, may be taken into account in computing any capital gain, and various reliefs, e.g. indexation allowance, taper relief or rollover relief, may be relevant. If there is no underlying asset, for example, in the case of an action against an adviser for negligent tax advice, the Revenue will exempt any gain on the disposal of the right of action.

The Revenue seeks to distinguish between a Zim right and a contractual (or statutory) right, and considers that no capital gains tax reliefs or exemptions are available in the latter case if, for example, a capital sum is received in compensation for a contract which is varied upon agreement by both parties. However, if one of the parties does not agree, the Revenue may seemingly accept that any compensation received in settlement of an action derives from the right of action, not from the varied right in the contract, so that the Zim principle may apply (Capital Gains Manual at paragraphs 12992e and 12036). The manner in which the Revenue would apply Extra-statutory Concession D33 must then be considered.

Underlying asset

If the subject matter of a contract or a Zim right is an underlying asset, e.g. trading premises, plant and machinery or stock, any compensation may be treated as relating to that asset. However, can there be an underlying asset in a simple trading agreement, such as free goodwill? For example, XYZ Ltd, a motorbike dealer, has its long-standing dealership agreement terminated by the motorbike manufacturer. The company would no doubt prefer this compensation windfall to be non-taxable, but may need to satisfy the Revenue that:

- it arises from a Zim right and not from a contractual right;
- there is no underlying asset;
- Concession D33 should be applied.

In Commissioners of Inland Revenue v Muller & Co (Margarine) Ltd [1901] AC 217, Lord MacNaghten defined goodwill as ‘… the benefit and advantage of the good name, reputation and connection of a business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old-established business from a new business at its first start’.

In the motorbike trade example of a long-standing trading agreement, it would seem possible to contend that the compensation was paid to acquire free goodwill generated and built up over a number of years, particularly if the dealership was taken over by the manufacturer, with the company either ceasing to trade or no longer continuing in the motorbike trade.

Incorporated or not?

If the compensation does relate to goodwill, and Concession D33 is applied, the tax treatment of any chargeable gain will depend on whether or not the trader is incorporated. For example, sole traders or partnerships may be entitled to claim capital gains tax taper relief. Alternatively, it may be possible for unincorporated traders to roll over the gain under section 152, Taxation of Chargeable Gains Act 1992.

For companies, the tax treatment depends on whether the goodwill falls within the scope of the intangible fixed assets rules in Schedule 29 to the Finance Act 2002, or whether it was an ‘existing asset’ (as defined in paragraph 118 of Schedule 29), such as the internally generated goodwill of a business carried on before 1 April 2002.

Rollover relief is potentially available in either case (albeit under different provisions), which is one possible advantage over the compensation being treated as a trading receipt where no trading losses are available to set off against it.

Happy ending?

Completing the marriage analogy from the start of this article, staying faithful to a single trading agreement may be a wise move. Should it all end in tears – a terminated agreement with compensation – some relief from capital gains tax may be on the horizon. On the other hand, those who play the field with multiple trading agreements could finish up suffering for their infidelity if it all turns sour (through revenue treatment), although the lucky ones will always land on their feet with trading losses to offset.

This article originally appeared in 'Taxation' 19 February 2004.