is compensation taxable?
This note explains our current understanding of when compensation we award is taxable.
It explains that in some circumstances, the law requires a financial business to deduct income tax at the basic rate – whether or not the consumer is a taxpayer.
the consumer's tax position
The tax treatment of the compensation awarded to a consumer is likely to depend on the circumstances of the case, the nature of the compensation and the consumer’s own wider financial and tax position.
We can only give our understanding of how compensation may be treated for tax purposes. It is something to be resolved between the consumer and HM Revenue and Customs (HMRC).
In some of the examples below, the compensation (or part of it) is usually taxable because it is interest.
- If the consumer is not liable for income tax at all, they can reclaim from HMRC any income tax deducted by the financial business.
- If the consumer is liable for income tax at the basic rate, and the business has not deducted tax at the basic rate, the consumer is responsible for telling HMRC.
- If the consumer is liable for income tax at a higher rate – whether or not the business has deducted tax at the basic rate – the consumer is responsible for telling HMRC.
- If the consumer is liable for capital gains tax, the consumer is responsible for telling HMRC. Financial businesses do not deduct capital gains tax.
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compensation for being deprived of money
In some cases, we tell the business to award the consumer compensation for being deprived of money. For example:
- An insurance company wrongly refused to pay Mr A’s insurance claim. We told the insurance company to pay Mr A’s claim plus interest on the claim from the date of the accident to the date of payment.
- A bank did not pay Mrs B the proceeds of her investment until June, even though the investment had matured in January. We told the bank to pay Mrs B interest on the proceeds from January to June.
- An investment company inappropriately advised Mr C to pay into one of its investment policies. We told the investment company to cancel the policy from the beginning and to refund Mr C’s contributions with interest.
In cases like these the compensation includes an amount for being deprived of money that the consumer would have been able to use. That part of the compensation is potentially subject to income tax, even if it is not described as interest.
Financial businesses are required – by law – to deduct income tax at the basic rate from such interest.
If the business deducts tax, it must pay that tax to HMRC and give the consumer a certificate of tax deduction if they ask for one – though most businesses will provide one automatically.
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compensation for investment loss
Where we award compensation for an investment loss – typically because the consumer's money was put in the wrong investment or account – the tax position depends on whether the consumer still has the wrong investment or account.
where the consumer still has the investment or account
In some cases, we tell the business to pay the consumer compensation for being sold the wrong investment or account – and the consumer still has that investment or account. For example:
- Mr D was planning to take out investment X – but a financial adviser persuaded him to take out investment Y which was an unsuitable alternative and did not perform as well as investment X. We told the adviser to pay Mr D what investment X would have been worth less the current value of the unsuitable investment Y.
- Miss E was planning to invest but had no particular investment in mind. An investment company wrongly advised her to take out an unsuitable investment – which then lost money. It was not possible to decide how Miss E would otherwise have invested her money. So we told the investment company to pay Miss E what her investment would have been worth if the capital had grown in line with the movement of a suitable benchmark less the current value of the unsuitable investment.
In cases like these, the compensation we award is for investment loss. This is usually based on what would otherwise have happened to the consumer’s money. This kind of compensation is not usually subject to income tax – even if it is calculated by reference to an interest rate.
The consumer may be liable to pay capital gains tax on the compensation. Whether or not capital gains tax is payable will depend on the consumer’s individual circumstances. So the businesses shouldn’t deduct capital gains tax from the compensation.
where the consumer no longer has the investment or account
In some cases, we tell the business to pay the consumer compensation for being sold the wrong investment or account – and the consumer no longer has that investment or account:
- Miss F was planning to invest but had no particular investment in mind. An investment company wrongly advised her to take out an unsuitable investment – which then lost money. To reduce her loss, Miss F cashed in the unsuitable investment a year ago. We told the investment company to pay Miss F:
- her loss (calculated as what her investment would have been worth a year ago if the capital had grown in line with the movement of a relevant benchmark less the sale price of the unsuitable investment); plus
- interest on that loss from the date the unsuitable investment was cashed in until the date the compensation was paid.
- Mr G was planning to take out investment X, but a stockbroker persuaded him to take out investment Y. This was an unsuitable alternative and did not perform as well as investment X. The unsuitable investment matured and paid out a year ago. We told the stockbroker to pay Mr G:
- his loss (calculated as what investment X would have been worth a year ago less the maturity value of the unsuitable investment Y) plus
- interest on that loss from the date the unsuitable investment matured until the date the compensation was paid.
In cases like these, the tax treatment of the two parts of the compensation is likely to be different.
The compensation for the investment loss to the date the unsuitable investment was sold (or matured) is not usually subject to income tax – although the consumer may be liable for capital gains tax on this part.
The interest for being deprived of the investment loss from the date the unsuitable investment was sold (or matured) to the date the compensation was paid is potentially subject to income tax.
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compensation where an account is reconstructed
In some cases, we tell the businesses to reconstruct an account. For example:
- A building society temporarily lost two of the mortgage repayments that Mr and Mrs H had made. We told the building society to reconstruct Mr and Mrs H’s mortgage account – so that the interest was adjusted to what it would have been if the repayments had been credited at the right time.
- A bank agreed an increased overdraft for Mr J, but forgot to update its computer system. The computer system treated the increased overdraft as unauthorised and applied charges plus a higher rate of interest. We told the bank to reconstruct Mr J’s account – removing the charges caused by its mistake and applying the correct rate of interest.
The tax position will be based on the account as reconstructed – and will be the same as if the business had never made the error.
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compensation where payment protection insurance (PPI) is mis-sold
In some cases, we award compensation because a PPI policy has been mis-sold. For example:
- When Mr K took out a loan with his bank, it mis-sold him single-premium PPI and added the premium to the loan. We told the bank to reconstruct the loan as if the PPI premium had never been added – and to repay the extra loan repayments Mr K had made on the premium, with interest on those from the date Mr K had paid them.
On the loan account, no tax liability is created. But the interest paid on the extra loan repayments refunded to Mr K, would be subject to income tax.
- When Miss L took out a credit card, the credit-card issuer mis-sold her monthly-premium PPI and included the premiums in the monthly credit-card payments. We told the credit-card issuer to reconstruct the credit-card account as if PPI premiums had never been added – and, if this created a credit balance in any period, to credit the account with interest for that period.
On the credit-card account, the tax position will be based on the account as reconstructed. The interest credited on any credit balance is potentially subject to income tax – like any interest credited to a bank account.
H M Revenue & Customs has published more detailed guidance on PPI compensation.
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compensation in mortgage endowment cases
Where we uphold a mortgage endowment complaint, we usually tell the business to put the consumer in the position they would be in now if they had originally taken out a repayment mortgage instead of the endowment mortgage. Our approach to compensation in these cases follows the guidance in the Financial Conduct Authority’s handbook (at DISP Appendix 1 – sometimes referred to by its previous name of "RU89" by some financial businesses).
Payment of compensation calculated in this way is unlikely to create any liability to income tax or capital gains tax. But there are some exceptions:
- Where the endowment policy is surrendered or sold, this may trigger a "chargeable event gain" liable to income tax. But the business will usually be liable to refund any tax (under DISP Appendix 1.5.9G) if the surrender or sale results from the compensation settlement.
- Where there is a delay between the calculation of compensation (in accordance with DISP Appendix 2) and payment, any interest payable on that compensation relating to the delay is potentially liable to income tax – as explained in section 3 above.
- Where the policy is cancelled from the outset and the premiums are returned with interest, instead of compensation under DISP appendix 1, the interest on the premiums is potentially liable to income tax.
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The tax treatment of compensation for pension cases is complex. Generally, we aim to place the consumer in the position that they would be in if the business hadn’t made the error.
Since April 2006 it has become more difficult for payments of compensation to be made into pension policies. If the compensation is paid by a third party, it will usually be treated as a contribution by the consumer – for which they might be entitled to claim tax relief.
Many cases also involve payments of compensation for the loss of income. That income would usually be liable to income tax – depending on the consumer’s circumstances. Our approach in those cases would be to calculate the consumer’s net tax loss and award that loss as the compensation.
Our understanding is that compensation paid in this way would not usually be subject to income tax.
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