Lee Sharpe looks at insurance and compensation costs and how related claims should be dealt with for tax purposes.
This article looks at the tax treatment of business insurance expenses and claim proceeds; also, the related proceeds that might arise from a mis-selling claim, as they are closely related. This is primarily considered from the perspective of income tax and non-corporates.
Insuring business risks
HMRC’s Property Income Manual at PIM2110 happily allows that landlords should be able to claim relief for premiums paid to cover:
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buildings;
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contents; and
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loss of rents or loss of profits due to business interruption.
This should apply not just when properties are actually being let, but also during void periods – simply, while the property is part of the rental business, and the landlord is exploiting (or would like to exploit) the property, so as to yield income. But once a property is no longer part of the property rental business, the corresponding insurance costs, just as with most other expenses, will likely not be incurred in the furtherance of that business, so will not be allowable.
In particular, beware:
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Personal or ‘keyman’ insurance – outside of policies designed to offset the cost of replacing critical employees in the business, the expense of a policy likely of benefit to the proprietor (such as their own life insurance) will typically be considered private (non-business) and disallowable.
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Policies with an investment element – a capital return, and therefore a non-business contribution embedded in the cost, will almost certainly not be allowable.
How to account for claim proceeds: A one-way street?
There is a ‘natural presumption’ that, if the insurance cost is deductible, then the insurance proceeds of a subsequent claim will fall within the scope of the business so that, generally:
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receipts covering the cost of repairs, etc., will typically be offset by those additional expenses; and
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excess repair costs will be allowable, while
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excess proceeds will be taxable;
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receipts to cover the loss of rents or profits will be recognised as income in the rental account.
Depending on the timing of remedial costs and claim proceeds, it may be considered appropriate to account for the receipts separately from the costs; HMRC’s guidance at PIM2040 confirms that this approach is acceptable.
However, it is not safe to assume either:
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the logical converse – that if the claim proceeds are taxable, then the cost of the premiums should have been allowable; or
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the logical inverse – that if the costs were not allowable, then the insurance proceeds must also not be taxable.
Simply put, HMRC will want the proceeds to be taxable, far more than to allow relief for the expenditure that gave rise to the entitlement to claim. For example, HMRC’s Business Income Manual at BIM40751 states: ‘The deductibility of insurance premiums for tax purposes will not determine whether a recovery forms part of trading income’ (emphasis added).
The guidance then goes on to list what HMRC considers will be business receipts (in this context).
This may seem unfair, but it is in line with fundamental principles. A private benefit to an insurance premium might act to restrict or deny tax relief, but the proceeds might still be taxable as a business receipt; likewise, capital expenditure on a fixed asset is generally not allowable, but that does not prevent income from subsequently exploiting that asset, then also being a taxable business receipt.
The capital trap: It’s not simply ‘either/ or’
It is often said that a receipt can be income or capital, but it cannot be both. In that vein, income tax takes priority over CGT. This is perfectly correct - until it is not. Summarising TCGA 1992, ss 37-39, one might say:
Where some (or all of) a receipt, or an expense, may fall within the income tax regime or the CGT regime, then that proportion thereof will be dealt with under income tax, in priority to CGT.
HMRC’s Capital Gains Manual confirms this at CG10260: ‘Any such charge to Income Tax precludes a charge to Capital Gains Tax in respect of that receipt (to the extent that it is so covered), but there may be a residual liability to Capital Gains Tax on any part of the receipt not so charged. Similarly, any expenditure which is or in some circumstances might be allowable in the computation of an Income Tax liability or notional liability is not allowable expenditure for Capital Gains Tax purposes.’
The implications of this are often seen where insurance proceeds cover the loss or (partial) destruction of an asset (also, as an aside, when capital allowances are involved). HMRC’s guidance at BIM40755 confirms that, where a repair cost has been claimed for income tax purposes, the capital receipt will be partly adjusted (diverted) to offset that expense in the business accounts.
Mis-sold Compensation: Hacketts v HMRC
Of late, we have had several cases of mis-sold financial products (e.g., interest rate hedging products). The ‘naughty’ part of these was where lenders offered business loans but conditional on the borrower also taking out one of these hedging products, and that hedging product was contrived to be very expensive, or to benefit the lender rather more than the borrower (or be both expensive and of limited benefit to the borrower). These products were sorely tested in the wake of the global financial crisis a few years later, and it seems many were found wanting.
In Hacketts v HMRC [2024] UKFTT 00749 (TC), the taxpayer brothers claimed and received seven-figure sums in 2014/15, in relation to the mis-selling of several hedging products starting in 2006. While the taxpayers had entered into these hedging products as part of the financing of their substantial property letting business, they tried to argue that the compensation was not taxable as an income receipt of the property business, nor was the (sizeable) interest on their claim subject to income tax.
It must be said that the taxpayers made quite the meal of their case by:
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submitting a 60-page ‘skeleton argument’ that amounted to a full written submission (to the point that the tribunal suggested they might reject submissions of such healthily porcine proportions, in future);
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trying to debar HMRC from the hearing – in the middle of the hearing; and
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a tortuous analysis trying to punch holes in the logic of HMRC’s arguments.
Essentially, the taxpayers tried to divorce the hedging products from the rental business, despite having claimed relief in their rental accounts for the hedging costs from 2006 (had the taxpayers won, HMRC would have been out of time to recover the tax on those ‘old’ expenses).
They argued that the compensation received was either in relation to an opportunity cost – a missed chance to turn the hedging payments to some other gain or profit – or, at worst, capital in nature; likewise, the interest. In other words, the initial outlay was not really allowable, so neither was the compensation.
The tribunal was able to reassure the taxpayers they had, in fact, been right all along; the hedging payments were indeed allowable from back in 2006 because of their relevance to the brothers’ property business; the compensation payments almost a decade later were likewise relevant. The interest was also taxable as income.
Conclusion
It is fair to say that courts have sometimes struggled to decide what compensation is actually for. But here, the tribunal wasted little time in concluding that the compensation payment was not for a missed opportunity cost, nor was it capital in nature. The general rule of thumb appears still to hold: if the initial expenditure is allowable in the business, then the proceeds are taxable in the business.
But that is as far as the logic holds; sometimes proceeds are taxable even if the initial payments were not allowable, and if the payments had not been allowed, that does not guarantee that any proceeds should not be taxed. The treatment of compensation or insurance payouts should be considered carefully, and specialist advice is highly recommended, particularly where the sums are substantial.
