Do you pay tax on personal injury compensation?
There have been reports in the press that claimants must pay tax on compensation. This is not the case - so why the confusion?
Claimants do not pay tax on injury compensation
If you receive financial compensation following an injury, specific legislation ensures that you do not have to pay tax on it. This is the case no matter whether the compensation is received as a lump sum or as staggered payments.
Tax is not payable, no matter whether the compensation was awarded by the court or as an out of court settlement.Back to top
Why the confusion?
Newspaper headlines suggesting that claimants must pay tax on compensation have caused consternation for people pursuing an injury claim.
The reports have given rise to concerns that compensation calculated to meet treatment costs could be depleted after tax deductions.
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.Back to top
Is the interest on personal injury payments taxable?
Interest can added to the compensation award and is calculated from the time of accident or injury time the date of settlement.
Legislation requires the entity paying the interest to deduct tax from the interest at source. The tax is therefore deducted before the payment is made.
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.Back to top
Some tax may be payable if payment is further delayed.
Even though a claim has been settled and an amount awarded, there may be 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.
A claimant was awarded £20,650 on 14 July 2014 but the payment was not made until 14 January 2015.
In this case a further £206.50 was added to represent the 6 months' interest. The £206.50 is the amount to declare on the tax return.Back to top
What if I invest the award and earn interest on it?
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.