COMPENSATION PAYMENTS - 26.08.2021

How to treat compensation payments?

Scope of CGT

It’s important to understand that capital gains tax (CGT) doesn’t just apply to actual disposals of assets, whether by sale or gift etc. It also applies to capital sums received that are “derived from assets”. Such capital sums can arise where there is no underlying disposal, and so it is important to make clients aware of the rules.

Where your client receives a capital sum derived from an asset that they are the beneficial owner of, and this payment is made in money or money’s worth, a deemed disposal will arise under s.22 Taxation of Chargeable Gains Act 1992 (TCGA) . A capital sum may be paid in respect of:

• a compensation payment for damage, loss or destruction, e.g. insurance proceeds
• a right to receive unascertainable contingent consideration, e.g. earn out rights
• as compensation for surrendering rights over an asset, or for refraining from exercising such rights; or
• as consideration for the use of, or exploitation of, assets.

Pro advice. There are certain types of capital sum which are excluded from this. For example, compensation for wrong or injury suffered by an individual in a personal or professional capacity is not taxable, being excluded under s.51 TCGA 1992 .

Compensation payments

As your client has indicated that the money is a compensation payment in respect of an asset, it will not be an excluded payment. This is different depending on whether the asset has been entirely lost or destroyed (so it is no longer owned), or if it has been damaged. There are then further rules that offer relief if the capital sum is used to restore or replace the asset. Let’s consider some possible situations.

Asset lost or destroyed

Where the asset is entirely lost or destroyed, any capital sum is treated as consideration for its disposal, i.e. the CGT computation uses the amount as if it were sales proceeds for a disposal. Any base cost of the asset is fully deductible, along with any enhancement expenditure. If the capital sum is lower than the allowable expenditure, an allowable loss will crystallise.

Pro advice. In some cases no capital sum will be received, e.g. because an asset was not insured or the policy terms and conditions were not adhered to. A disposal, and so an allowable loss, still arises due to s.24 which permits a negligible value claim to be made as long as the individual acquired the asset directly or as a result of a no gain, no loss transfer, e.g. from a spouse.

Pro advice. If the asset still physically exists, any scrap value must be taken into account as additional proceeds when calculating the loss.

Example. Wendy owns an antique machine that is in full working order. It was purchased for £50,000. The machine was destroyed in a fire, leaving only scrap metal worth £1,000. Unfortunately, Wendy had forgotten to renew her insurance policy and receives no compensation. Her allowable loss will be £50,000 less the scrap value, i.e. £49,000.

Don’t forget that if assets are not chargeable assets, e.g. cars, any loss will not be an allowable loss for CGT purposes.

Pro advice. Buildings are subject to special rules because most of the value is attributable to the underlying land, which is unlikely to become lost or destroyed. See HMRC’s guidance at CG15742 (see Follow up ) for a discussion of these rules.

Replacement assets

If the compensation payment is wholly or partly used to acquire a replacement asset, a form of rollover relief may be available. If the whole amount is used within one year of receiving it, the relief works by treating the proceeds for the deemed disposal of the old asset to be an amount that gives rise to neither a gain nor loss. As a result, the base cost of the replacement asset will be reduced by the gain that would otherwise have arisen.

Where only part of the capital sum is used to acquire a replacement, partial relief will be available as long as the amount unused does not exceed the gain on the deemed disposal. The gain on the deemed disposal will then be restricted to the amount not used in acquiring the replacement, i.e. the cash retained by the owner.

Example. David purchased a watch for £10,000. Following a break-in at his home the watch was stolen and David received an insurance payout of £15,000. David finds a similar watch for £12,000 and uses the insurance money to buy it. The gain on the original asset is £5,000 but David can elect to restrict this to £3,000. The base cost for the new watch will be reduced by the difference, i.e. £2,000.

Asset damaged

Where an asset is damaged in a way that diminishes its value, but is not entirely destroyed, the treatment is different. Generally, a compensation payment your client receives in respect of damage to an asset is treated as a part disposal, as long as your client retains ownership of it.

The portion of the allowable expenditure in the CGT calculation is worked out by multiplying the allowable expenditure by (A/A+B), where A is the capital sum received, and B is the market value of the asset on the date the sum was received. If your client has incurred any expenditure before receiving the capital sum, e.g. a temporary repair so that the asset can continue to be used to some degree, this is treated as enhancement expenditure, and can be included in the allowable expenditure to be apportioned by the (A/A+B) formula.

Amount used to restore asset

If the capital sum is wholly used to restore the asset, or if all but a “small” amount that isn’t reasonably required for restoration, an election under s.23(1) can be made that there is no part disposal, and the capital sum is simply deducted from the allowable expenditure on a subsequent disposal. This will also be available if the capital sum is itself “small” in comparison with the value of the asset.

Pro advice. “Small” is not defined in TCGA 1992 , but is taken to mean no more than 5% of the total capital sum or value of asset as appropriate. HMRC also accepts that a capital sum is small if the amount or value of the receipt is £3,000 or less, regardless of whether it exceeds 5%.

If the unused amount is not small the election under s.23(1) does not apply so there will be a chargeable disposal. However, s.23(5) allows a claim to be made that the unused part is the consideration for the part disposal, rather than the full capital sum.

Pro advice. The unused amount also replaces A in the part-disposal formula.

Example. Claire buys an asset for £30,000 and insures it against fire and theft. In 2021 the asset was partly damaged in a fire and she receives £10,000 from the insurance company. She manages to find a specialist who restores the asset for £6,000. The restored value is £50,000. The unused amount is not “small”, so it represents proceeds for a part disposal. The allowable expenditure is £30,000 x £4,000/(£4,000 + 50,000) = £2,222. Part of the restoration cost is also deductible using the same fraction, i.e. £6,000 x £4,000/(£4,000 + £50,000) = £444. The gain on the part disposal is therefore £1,334 (i.e. £4,000 - £2,222 - £444).

Pro advice. If the capital sum exceeds the total allowable expenditure, full relief is only available if the whole sum is used in restoring the asset. If not, the only other relief is a claim under s.23(2) to deduct all the allowable expenditure, i.e. without apportionment, from the amount of the capital sum in the CGT calculation of the part disposal.