Tax might become more complicated in the following instances:
PERSONAL INJURY
Understanding how tax will apply to your compensation package
Compensation payments are sums of money paid to people who have experienced injury or harm in an accident or through medical negligence. In general, personal injury compensation is tax-free, but in some circumstances, you will have to pay tax on some interest you receive.
In this guide, we'll explain:
- When personal injury and medical negligence compensation is tax-free.
- The situations where tax may apply to compensation or related payments.
- How interest on compensation is treated for tax purposes.
- The difference between net and gross loss of earnings in compensation claims.
- How tax rules can differ for overseas claims and structured settlements.
- How compensation may affect means-tested benefits and how a Personal Injury Trust can help protect your award.
When are compensation payments tax-free?
As a general rule, compensation for personal suffering and injury is tax-free, meaning it is not subject to capital gains tax, income tax, or national insurance.
Interest will accrue on your compensation between the date of the incident and the date of settlement. That’s when the other side agrees to pay you compensation or a judge award in your favour if it goes to court. Tax is not payable on this interest.
Below, we explore what is considered a personal injury and what is considered medical negligence under UK law.
Personal injury compensation
Personal injuries that are viable for compensation range across a broad spectrum, including:
- Injuries and illnesses caused by negligence: This includes physical injuries, psychological injuries, or illnesses caused by negligence that could lead to an employer & public liability claim.
- Non-physical harm: This includes harm beyond physical injuries, including emotional harm. For example, distress, embarrassment, and loss of reputation or dignity. Unfair discrimination or defamation also counts as non-physical harm.
This means that you can pursue compensation for personal injuries the same way, whether it’s for a broken arm or for emotional damages.
Medical injury compensation
Medical negligence can be defined as healthcare delivered to a low standard that results in injury or harm to a patient.
Compensation for the harm you suffer from negligent medical treatment is also tax-free.
It falls under the same exemption as personal injury claims, as the law considers a medical injury the same as any other personal injury one could suffer.
Exceptions to tax-free compensation
Not all compensation is tax-free. The following situations may result in tax being applied:
- Interest accrued on compensation payments: The interest already included in your personal injury claim, covering the period up to the date your claim is provided, is tax-free. Extra interest that builds up after your award, like interest from payment delays and on investment earnings, is taxable.
- Gross loss of earnings: This includes gross salary, gross bonuses, and gross commissions you didn’t get the opportunity to earn because you had to take time off work.
However, your loss of earnings should be calculated on your net earnings (after tax) in your claim, and so as long as your compensation is based on net loss of earnings, then it will be treated as exempt by the HMRC.
Simply put, net loss of earnings = not taxable. This is known as the Gourley principle (from the 1956 House of Lords case British Transport Commission v Gourley).
To illustrate, let’s look at some examples:
Interest
Alice gets £40,000 in damages for a personal injury, including £2,000 in tax-free interest. However, she doesn’t receive the money until six months later. Because of the delay, she gets an extra £500 in interest. She’ll need to pay tax on that £500.
Serious personal injury
A builder is seriously injured by falling debris and awarded £100,000. They get £70,000 for net loss of earnings and £30,000 for their pain and suffering, both elements are not taxable. (NB; If the loss of earnings had been calculated on the builder’s gross earnings however, they would have to pay tax on that element.) They accrue £2,000 in interest between the date of the accident and the settlement which they pay no tax on. It takes two months for the payment to clear which earns them an extra £700 in interest on which they do pay tax.
International injury cases
If damages are awarded by a foreign court, the tax implications of a personal injury settlement, made by a foreign court, is going to depend on the laws of that country.
Structured settlements
These involve providing regular compensation payments, as opposed to receiving compensation as one lump sum. If a court approves the settlement as your compensation award, both the money and any interest you earn on it is tax-free. If, however, you take the lump sum and buy an annuity, then the interest you earn will be taxable. An annuity is a financial product that pays you a set sum of money at regular intervals – they’re most commonly associated with pensions.
Tip: You should work with both legal and tax experts on your compensation claim to help you understand how each part of your settlement is taxed and ensure you don’t miss any important details.
Why choose Fletchers Solicitors?
We know that managing a personal injury claim can be overwhelming, especially it comes to compensation and finances With Fletchers on your side, you’ll have expert legal representation and dedicated support at every stage.
We’re listed on the prestigious Legal 500 as a top-tier firm and top-ranked on the Chambers list. We’re also one of the Times Newspaper’s best law firms.
Our colleagues have a deep understanding of how tax can affect compensation claims and they remain focused on maximising the award you receive.
Our teams are always on hand to answer any questions you have, and they always look forward to hearing from clients.
FAQs about tax on compensation payments
Is personal injury compensation always tax-free?
No, personal injury compensation is not always tax-free. Compensation for personal injuries whether physical, emotional, or professional is usually free from capital gains tax. However, any interest you earn on your compensation after the date you’re awarded it is usually taxable, as are lost earnings.
How is interest on compensation taxed?
Interest included in your damages award is usually tax-free if it covers the period from the accident to the date of the court award. Any interest you make after the date of award or from investing your compensation is taxable.
What is the 52-week rule for compensation?
The 52-week rule in compensation means that the Department for Work and Pensions (DWP) usually lets personal injury compensation be excluded from calculations for means-tested benefits for a year.
Can compensation payments affect other benefits or tax allowances?
Yes, they can.
After 52-weeks pass and the 52-week rule no longer applies, your benefits might be reduced or stopped if the remaining compensation pushes your savings above a certain threshold.
However, a Claimant can place their damages in a Personal Injury Trust for damages relating to their own accident which will essentially ring-fence their damages, i.e., exempting them from consideration for means-tested benefits post-settlement. You should always speak to a financial advisor in relation to setting up a Personal Injury Trust.
Do I need to declare overseas compensation?
Yes, you do. UK tax residents still need to declare taxable compensation from overseas to HMRC.