What is the Tax Status of Compensation for Financial Product Mis-Selling?

Is compensation paid to individuals whose businesses have failed due to mis-selling of financial products subject to Income Tax? In a decision that will disappoint many victims of bank wrongdoing, the First-tier Tribunal (FTT) has answered that question in the affirmative.

The case concerned seven brothers whose property letting business had been mis-sold interest rate hedging products (IRHPs). The business subsequently failed, allegedly due to the high interest rates imposed by the IRHPs. After they lodged complaints, the relevant bank paid them basic compensation totalling almost £360,000. HM Revenue and Customs (HMRC) took the view that the payments were taxable and raised demands against the brothers, totalling over £43,000.

In challenging the demands, the brothers argued that the compensation had not been paid in respect of the business's lost profits, but in recognition of the bank's wrongdoing. The cause of the compensation was the mis-selling and the sums received should be viewed as non-taxable capital, rather than income.

In rejecting their appeal, however, the FTT preferred HMRC's argument that the sums were paid by way of reimbursement for excessive expenditure by the business. The compensation arose from the carrying on of the business, while it existed, and was thus properly viewed as a post-cessation receipt, within the meaning of Section 349 of the Income Tax (Trading and Other Income) Act 2005.

Although it could be said that the sums had been paid 'for' the mis-selling, the bank's wrongdoing was merely the source of the legal right to compensation, which did not include a punitive element. The payments were thus revenue receipts and constituted taxable income. The FTT also noted that the brothers' right of action against the bank constituted an asset. In those circumstances, the compensation would have been subject to Capital Gains Tax even had it been regarded as a capital item.