To What Extent are Termination Payments Taxable?

So, the great news is you have 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. This 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 their marginal income tax rate, which for higher earners can reach the top rate.

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.

Where a compensation payment cannot be attributed in any way to the disposal of an underlying asset, it may fall outside CGT under an HMRC concession, subject to limits and, above a certain amount, a formal claim to HMRC. The limits attaching to that concession change, so the current position should be checked before relying on it.

If HMRC links the payment to the disposal of an asset, any gain above the annual exempt amount is taxed at the applicable CGT rate. Business Asset Disposal Relief (formerly Entrepreneurs’ Relief) may also apply, reducing the rate on qualifying gains. Where it is available, 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 a result of the agent’s efforts.

Outstanding commissions

As many of you will know, Regulations 7 and 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 efforts. This is separate from the compensation or indemnity payment discussed later in this article.

Any award of damages or settlement in respect of commission relates to profits made by commercial agents in respect of their trade. The general rule is that a damages award representing 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 month for the first year of the contract;
• 2 months for the second year commenced; and
• 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, 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 a 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 an 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. Where it is classed as a capital receipt, it may be possible to structure the payment so that certain tax reliefs are available, reducing the effective rate further, or even to argue that the payment does not arise from the disposal of a chargeable asset. 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. Agents should seek accounting and legal advice as to what tax may be payable and whether any tax relief is available.

Article written by Adam Maher, Partner at Myerson LLP. Adam is a partner in the busy commercial litigation department, which is rated “top tier” by the Legal 500.
Myerson Solicitors LLP, Regent Road, Altrincham, Cheshire WA14 1RX. Email: lawyers@myerson.co.uk. www.myerson.co.uk

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, since the answers given may not cover all possible angles, aspects, relevant considerations or points of law, and so all information given above needs in every instance to be referred for legal advice for clarification and amplification before being relied upon.