Do you pay tax on personal injury compensation?
Newspaper headlines regarding Claimants finding they have to pay tax on compensation payments may have caused consternation for people pursuing claims for personal injury. They may wonder if any compensation they receive for damages might be depleted by income tax obligations.
The main focus of the press reports was compensation for mis-sold payment protection insurance (PPI) on credit cards, loans or other lending products where interest (generally at a rate of 8% per year) was added to the repayment of the original premiums. Unlike interest paid by banks and building societies, the tax was not deducted at source - leaving Claimants needing to declare the interest as income on their tax returns.
Is interest on personal injury payments taxable?
The following payments for personal injury are exempt from tax:
- Compensation or damages awarded for personal injuries either paid as a lump sum or over a period of time. It does not matter whether this was awarded by the Court or was an out of court settlement.
- Any interest up to the time of judgement awarded by a court on compensation or damages for personal injuries. Such interest may be granted for the period, or any part of the period, from the date the cause of action arose to the date of the award. Legislation requires the person paying the interest to deduct income tax at source from it before payment.
For example; A Claimant sustained an injury on 1 January 2013 and brought a claim, which was eventually settled on 14 July 2014. An award of £20,650 was made, which represented £20,000 damages and £650 for the interest from 1 January 2013 to 14 July 2014.
No tax would be payable on the £20,650 as the interest (already tax-deducted) represents the amount that the Claimant would have accrued had the £20,000 been paid on the day of the injury up until the date of settlement.
Be aware that there may be some tax to pay if payment is further delayed.
Even though a Claim has been settled and an amount awarded, there may be further delays in the Claim being paid.
Any interest that the payer adds to the compensation because of a delay in payment is taxable because the interest is likely to be paid gross (no tax deducted). It should therefore be declared on any tax return.
For example; although the Claimant had been awarded £20,650 on 14 July 2014, payment was not made until 14 January 2015. A further £206.50 was added to represent the 6 months' interest. The £206.50 is the amount to declare on the tax return.
If the damages award is invested, any interest generated would be liable for tax. This is usually taxed at source for basic rate taxpayers, but would need to be declared on a self-assessment return or to HMRC.