To What Extent are Termination Payments Taxable?

by Adam Maher
Partner, Myerson LLP

So, the great news is you’ve
successfully settled your
commercial agency claim (or, for
the unlucky few, you have
withstood the pressure of a court
trial and been awarded damages
by a court). The bad news is that
the taxman may well be able to get
his hands on some of those sums.
Regent Road, Altrincham
Cheshire WA14 1RX
Email: lawyers@myerson.co.uk
www.myerson.co.uk
Myerson Solicitors LLP Article written by Adam
Maher of Myerson LLP.
Adam is a partner in the busy
commercial litigation
department, which is rated
“top tier” by the Legal 500.
by Adam Maher
Partner, Myerson LLP
This therefore begs the question: are there tax efficient
ways in which a settlement can be structured to limit the
amount of tax that may be payable?
Unfortunately, tax legislation offers little assistance in
determining whether and to what extent compensation or
damages receipts are taxable. The tax position has
developed partly through legislation, partly through
decisions made by the court and partly through guidance
provided by HMRC. As with most tax issues, the legal and
accounting position is complex.
INCOME OR CAPITAL
The first step is to establish whether the compensation or
damages are income or capital in nature. The basic position
is that damages payments will be taxable income for the
claimant if both of the following apply:-
1.The receipt is a receipt of the trade, profession or
vocation; and
2.The receipt is income rather than capital.
To the extent that the compensation or damages satisfy
both of these criteria, they will be subject to tax in the
hands of the recipient. For an individual that income is
taxed at income tax rates which depending on earnings
may be as high as 45%.
If not income in nature, this does not necessarily mean that
the payment will be tax free, as it may be subject to tax in
respect of capital gains (“CGT”). Taxable gains arise where
there is a disposal, or part-disposal, of an asset. The receipt
of a payment “by way of compensation for any kind of
damage or injury to assets or for the loss, destruction or
dissipation of assets or for any depreciation or risk of
depreciation of an asset” is a disposal of that asset.
To the extent that a compensation payment cannot be
attributed in any way to the disposal of an asset, the first
£500,000 of any payment will be exempt from CGT,
meaning it will be tax free. In addition, a claim may be made
to HM Revenue & Customs for any amount in excess of this
to be exempt from capital gains tax.

If HMRC links the payment to the disposal of an asset, any
gain above £10,900 for an individual will be taxed at 18%
(and arguably Entrepreneurs’ Relief may apply which would
reduce the tax rate to 10%). This can be a significant saving
on the income tax rates.
WHAT SUMS FALL DUE TO AN AGENT ON
TERMINATION?
Upon termination of an agency, a termination payment
(either compensation or indemnity) is usually due. In
addition an agent may also be paid damages to
compensate for a principal’s failure to provide adequate
notice of termination and also for commissions due on
orders placed (both before and after termination) as result
of the agent’s efforts.
OUTSTANDING COMMISSIONS
As many of you will know, Regulations 7 & 8 of the
Commercial Agents (Council Directive) Regulations 1993
(“the Regulations”) entitle commercial agents to payment
of commissions due on orders placed up to the date of
termination of the agency relationship and for a reasonable
period after termination on orders generated through the
agent ‘ s ef for t s . Thi s i s separate from the
compensation/indemnity payment which will be discussed
later in this article. Any award of damages or settlement in
respect of commission relate to profits made by
commercial agents in respect of their trade. The general
rule is that a damages award that represents compensation
for loss of profits from a trade will itself be a trading receipt
and will result in an income tax liability.
DAMAGES RECEIVED FOR BREACH OF CONTRACT
Regulation 15 of the Regulations provides minimum notice
periods that have to be given by either party when
terminating the agency contract. These are:-
1.1 month for the first year of the contract;
2.2 months for the second year commenced; and
3.3 months for the third year commenced and for
subsequent years.
Neither the agent nor the principal can agree shorter
periods of notice. Usually the damages awarded to
compensate an agent for failure to provide adequate
notice equate to the extra commission that could have
been generated by the agent over the period. This being
the case, any damages payable for breach of contract
would also be considered a trading receipt and on that
basis, such damages would be subject to an income tax
liability.
IS TAX PAYABLE ON A COMPENSATION OR
INDEMNITY AWARD?
At termination an agent will normally be entitled to either
an indemnity or compensation payment. These are simply
methods of calculating the payment and do not determine
its nature for tax purposes.

Although intended to compensate agents for the loss of a
business and therefore arguably the loss of a capital asset,
HMRC guidance in this area states that a receipt under
Regulation 17 for the cancellation of a trade agreement will
be revenue in nature and will therefore be taxable as
income in the hands of the claimant.
There is however, an exception, which arises from the 1935
tax case of Van den Berghs Ltd -v- Clark. This case states
that where the loss of agency is substantial to the agent,
then payment for such a loss should be treated as a capital
payment rather than an income payment.
In the case of Barr Crombie and Co Ltd -v- CIR, for
example, the agent lost over 80% of its business at
termination of a particular agency. The termination
payment was therefore classed as a capital receipt rather
than in income receipt.
It will therefore depend on the facts in each case as to
whether a compensation or indemnity payment should be
treated as a capital or income payment.
In cases where the compensation or indemnity payment is
classed as a capital receipt, it may be possible to structure
the payment such that certain tax reliefs are available, thus
reducing the tax rate still further, or even to argue that the
payment does not arise from disposal of a chargeable
asset, such that the first £500,000 will be tax exempt.
Specific tax advice should be sought.
CONCLUSION
Given the amount of uncertainty about the amount of tax
that will be payable, some thought should be given to the
structure of any payments made under the Regulations and
agents should seek accounting and legal advice as to what
tax may be payable and whether any tax relief is available.

Myerson Solicitors LLP

Regent Road, Altrincham
Cheshire WA14 1RX
Email: lawyers@myerson.co.uk
www.myerson.co.uk

Article written by Adam
Maher of Myerson LLP.
Adam is a partner in the busy
commercial litigation
department, which is rated
“top tier” by the Legal 500.

Disclaimer: This column does not contain legal advice and is for general guidance only.
Agentbase, Myerson LLP and the writer accept no liability in connection with the general
guidance given in this column. Please ensure that you obtain legal advice before acting in
reliance upon anything in this article. For example, please be clear that the answers given
in this column may not cover all possible angles, aspects, relevant considerations and/or
points of law and so that all or any information which is given above needs in every
instance to be referred for legal advice for clarification and amplification, before being
relied upon

 

 

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