Is tax payable on compensation for damaged property?

Compensation

In 2020 our sole trader’s insurer agreed to compensate him for the financial loss resulting from damage to his trading premises. However, he hasn’t used all the compensation money for the repairs. He still has around £15,000 and he wants to know if it’s taxable.

Taxable or not

The first step in deciding the proper tax treatment is to establish precisely what the payment is for. For example, compensation for loss of profits is taxable in the same way as trading income, whereas compensation for theft or loss of equipment is usually dealt with under the capital allowances (CAs) rules as if the owner had sold the equipment for the amount received from the insurer.

Building damage

In our trader’s case the money he received was for damage to his trading premises. There are rules for dealing with transactions relating to land and buildings. They are so-called capital transactions and so they fall within the capital gains tax (CGT) regime.

There are further special rules for working out the CGT liability on a capital sum which is derived from an asset without it being sold or transferred. For example, compensation payments for damage to or loss/destruction of a building or other capital asset.

The special rules include exceptions which allow the payee to defer or potentially escape CGT on the compensation payment.

Exceptions from CGT

The exceptions mentioned above apply where the money received is:

• fully used to repair/restore the building etc.
• partly used to repair/restore the building etc.; the unused part wasn’t “reasonably required” for the repair/restoration and was small compared to the total compensation received; or
• small compared to the value of the building etc.

As the total compensation payment received by our trader was £98,000 and wasn’t fully used to restore his premises, neither of the first two exceptions can apply. However, the third does because the value of the building is £350,000, and HMRC considers that “small” means less than 5% (i.e. £17,500). It seems like good news. He can elect to use the third exception and so avoid, or at least defer, CGT until he sells the property.

A better option? If our trader chooses not to elect to use the exception and instead accepts the capital gain he will save tax. The gain is worked out using normal CGT principles. This means the gain will be somewhat less than the compensation amount. Our trader can use his annual CGT exemption to reduce the taxable gain making it tax free.

While electing not to treat a compensation payment as resulting in a taxable gain might seem attractive at first sight, it is worth crunching the numbers before deciding. It might save tax to accept the gain if it’s not significantly greater than the annual CGT exemption.