The tax implications of settlement payments are often overlooked in the process of resolving disputes. However, the tax treatment of these payments should be part of the parties’ consideration in settlement and for ensuring compliance of the law. Settlement payments can attract significant financial consequences if the associated tax liabilities or reliefs are not properly accounted for. It is therefore imperative for parties to pay attention to settlement agreement tax.

Whether the payment involves returning debts, recovering rent, unpaid invoices, or employment-related compensation, the tax treatment will depend on the very nature and purpose of the payment.

Returning Debts and Interest Payments 

Settlements involving the repayment of debts and interest are among the most common scenarios. The repayment of the principal debt is not subject to tax for the recipient, as it is considered a return of capital rather than income. Similarly, for the payer, repaying the principal is not deductible because it represents a capital obligation rather than a trading expense.

However, interest payments included in a settlement are treated differently. For the recipient, interest is taxable as income and must be reported in the tax year it is received. For the payer, interest payments may be deductible as a business expense if they are incurred wholly and exclusively for the purposes of trade. It is important to ensure that settlement agreements clearly separate principal repayments from interest payments to avoid confusion about their tax treatment.

General interest on judgment debts, such as that arising from the non-payment of a settlement payment amount, is also considered to be taxable income.

Recovering Rent 

In cases involving rent disputes, the tax implications depend on whether the payment relates to unpaid rent or compensation for other breaches of lease terms. For landlords, recovering unpaid rent through a settlement is taxable as rental income. This income must be reported in the tax year it is received, regardless of when the rent was due. Compensation for breaches of lease terms, such as failing to maintain the property, may be treated as either income or capital depending on the nature of the payment.

For example, if the compensation is used for repairs, it will likely be treated as income. If it compensates for permanent damage or loss, it may be considered a capital receipt. For tenants, payments made to settle unpaid rent claims are generally deductible as business expenses if the rent relates to a property used for business purposes. However, compensation for dilapidations or other lease breaches are not usually deductible unless they are directly linked to the tenant’s business activities.

Recovering Trade Invoices

Disputes over unpaid trade invoices are another common scenario in which settlement payments require careful tax consideration. For recipients, settlement payments for unpaid invoices are taxable as business income. For example, if a supplier recovers unpaid invoices through a settlement, those payments are treated as trading receipts and taxed accordingly. In the case of payers, settlement payments to resolve unpaid invoices are generally deductible as business expenses, provided the invoices relate to goods or services used in the course of trade. Any additional components of the settlement, such as interest or penalties, should be clearly identified in the agreement to ensure proper tax treatment.

For cross-border disputes, additional complexities arise when settlement payments are received overseas. The recipient must consider whether the payment is subject to tax in the jurisdiction where it is received and whether any double taxation treaties apply to prevent the same income from being taxed in both countries.

For example, if a UK-based business receives a settlement payment in another country, it may need to report the income to HMRC while also complying with the tax laws of the foreign jurisdiction. Currency exchange rates at the time of payment can also affect the amount of tax owed. Engaging a tax adviser with expertise in cross-border matters is essential to navigate these issues effectively and avoid penalties for non-compliance.

Employment-Related Settlements 

Employment-related settlement payments can also have varied tax implications. Payments for unpaid wages or bonuses are taxable as employment income and are subject to income tax and National Insurance contributions. Statutory redundancy payments are tax-free up to £30,000, with any amount above this threshold subject to income tax. Payments in lieu of notice (PILON) are generally taxable unless the settlement qualifies for specific exemptions. Compensation for personal injury or illness is typically tax-free, and compensation for discrimination claims may also be exempt, depending on the circumstances. Employees should carefully review settlement agreements to ensure that the payments are properly classified and any available exemptions are applied.

Addressing Tax Implications Early 

Tax implications should be addressed early in settlement negotiations to avoid surprises and ensure compliance with HMRC rules. Both parties should clarify the nature of the payment and consider whether any reliefs or deductions apply. VAT implications should also be addressed, particularly for disputes involving rent, trade invoices, or services.

Engaging a tax professional or legal adviser can help parties navigate these complexities and structure the settlement in a tax-efficient manner. By addressing tax implications such as settlement agreement tax proactively, parties can avoid costly mistakes and ensure that the settlement achieves its intended financial objectives.

At Lisa’s Law, we specialise in advising clients on dispute resolution and settlement. Whether you are recovering rent, resolving debt, negotiating employment-related settlements, or dealing with cross-border disputes, our team can provide the guidance you need to resolve dispute and to structure settlement agreements.

Have questions? Get in touch today!

Call us on 020 7928 0276, we will be taking calls from 9:30am to 6:00pm.

Email us on info@lisaslaw.co.uk.

Use the Ask Lisa function on our website. Simply enter your details and leave a message, we will get right back to you: https://lisaslaw.co.uk/ask-question/

For more updates, follow us on our social media platforms! You can find them all on our Linktree right here.

Sumit Singh

See Full Bio

Imagine you have just wrapped up another hectic year of running your business. Then, out of the blue, a letter from HMRC arrives. It claims you have underpaid your corporation tax and includes a hefty corporation tax assessment demanding immediate payment. But as you check your books, you realise something does not add up. HMRC has disallowed legitimate expenses or misclassified some of your income. What can you do?

Mistakes like these happen more often than you might think. By understanding the steps involved and when to seek professional advice, you can protect your business and ensure you’re only paying what you are genuinely required to.

The First Step: Asking HMRC for a Review

The first step in disputing a tax assessment is to ask HMRC to review their decision. This must be done within 30 days of receiving the assessment notice. In your request, explain why you think the decision is wrong and include any supporting documents, such as receipts, invoices, or business records.

For example, if HMRC claims your travel expenses are not deductible, you could provide evidence showing those trips were directly related to client meetings or conferences. Once they’ve received your request, HMRC will assign the case to a review officer who was not involved in the original decision.

This initial review process is your first opportunity to resolve the matter without the need for a formal tribunal hearing, making it an important step to approach thoroughly and strategically. Failing to provide everything that is asked for, or to give consistent and accurate explanations for any gaps, could result in HMRC maintaining their decision against you.

The First-tier Tribunal: Where Facts Are Decided

If you’re not happy with the outcome of HMRC’s review, the next step is to take your case to the First-tier Tribunal (Tax Chamber). This is where your case will be examined in detail by an adjudicator, making it the most important stage of the entire appeals process.

The tribunal operates much like a court but is less formal and designed to be accessible. Nevertheless, the procedural steps are strict and closely resemble those of a court hearing. You or your representative will have the opportunity to present your case, submit evidence, and, if necessary, call witnesses. For example, if HMRC argues that certain expenses were personal rather than business-related, you could bring in your accountant, employee, or travel agent as a witness, and submit additional records demonstrating how those trips and expenses were essential to your business.

The tribunal’s primary role is to establish the facts and apply the law to them. It is not only the evidence presented that matters but also how the testimony is given. The credibility and clarity of witnesses can significantly influence the outcome. This makes it crucial to consider having professional legal representation to manage your case.

Once the tribunal issues its decision, this will typically be the final word on factual matters. Later stages of the appeal process, such as the Upper Tribunal, generally will not revisit the facts or hear from witnesses unless there are exceptional circumstances.

What Happens If You Disagree with the First-tier Tribunal’s Decision?

If the First-tier Tribunal rules against you, you can apply for permission to appeal. Your application should clearly identify the grounds for appeal, which must involve a point of law rather than a dispute over the facts.

Grounds for appeal include situations where the tribunal has: i) Misapplied or misinterpreted the law, ii) Failed to give adequate reasons for its decision, iii) Considered irrelevant factors or failed to consider relevant ones or iv) Acted procedurally unfairly.

If the First-tier Tribunal refuses your application for leave to appeal, you can also apply directly to the Upper Tribunal for leave to appeal. The Upper Tribunal will review your application and decide whether to grant permission based on the legal grounds you have raised.

Upper Tribunal Appeals: Focusing on Legal Issues

If permission to appeal is granted, your case will proceed to the Upper Tribunal. Unlike the First-tier Tribunal, the Upper Tribunal does not re-examine the facts or hear new evidence. Instead, it focuses solely on whether the First-tier Tribunal made an error of law. For example, if the First-tier Tribunal misunderstood how allowable expenses should be calculated under tax law, the Upper Tribunal would consider whether this legal mistake affected the outcome. The Upper Tribunal may call a hearing to allow the parties to present their viewpoints.

If the Upper Tribunal finds that an error of law was made, it may set aside the First-tier Tribunal’s decision and either substitute its own decision or send the case back to the First-tier Tribunal for reconsideration.

While it’s rare, some appeal cases may eventually reach the Court of Appeal or Supreme Court if they involve significant legal issues that have wider implications. However, for most small businesses, the First-tier Tribunal represents the most critical stage of the process.

Why Businesses Owners Should Take Action

Dealing with a tax assessment can be stressful, but the appeals process is designed to ensure fairness. A skilled lawyer can assist with every stage of the process, from managing your case and preparing evidence to developing a strategy and advocating on your behalf. They will analyse your case thoroughly, identify any gaps in your evidence, and highlight weaknesses in HMRC’s position. An experienced lawyer’s ability to present these points effectively during the hearing can have a significant impact on the outcome.

If you’re considering appealing a tax assessment, don’t hesitate to reach out to Lisa’s Law. Our team is here to guide you every step of the way and ensure your case is presented as effectively as possible.

Have questions? Get in touch today!

Call us on 020 7928 0276, we will be taking calls from 9:30am to 6:00pm.

Email us on info@lisaslaw.co.uk.

Use the Ask Lisa function on our website. Simply enter your details and leave a message, we will get right back to you: https://lisaslaw.co.uk/ask-question/

For more updates, follow us on our social media platforms! You can find them all on our Linktree right here.

Sumit Singh

See Full Bio