Chris Williams looks at how HMRC treats compensation for mis-sold financial products.
It may seem to be adding insult to injury for tax to be payable on compensation for a loss, but that can be the result. Therefore it is important to know what is and isn’t taxable.
Compensation or interest?
This is the most fundamental difference; the compensation is meant to put the claimant in the position they would have been in if they had not been mis-sold the product concerned.
Compensation is usually either a refund of premiums paid, or a payment to make up the shortfall in profits on the policy.
Interest represents income lost while waiting for compensation.
Refunded premiums
Most mis-selling compensation derives from personal insurance contracts such as life assurance and payment protection insurance. Refunds of premiums are only taxable if you claimed a tax deduction for the premium, such as product insurance or HP agreements on items bought for business use.
Compensation for lost profits
These will usually arise on investments such as insurance bonds and endowments, so the most important factor is likely to be how the compensation is paid. If additional amounts are added to (say) an endowment policy to make up a shortfall, they will be taxed in the same way as if the policy had paid out the increased amount. In many cases, this will mean that there is no tax to pay, provided the policy has paid out on maturity. If the policy is surrendered, wholly or partly, before it has run its full term there may be a ’chargeable event’ which is only liable for tax if the claimant pays higher or additional rate income tax.
If you receive compensation on a policy that is continuing in existence, HMRC will treat your compensation as a repayment from the policy, potentially giving rise to a chargeable event. This can be advantageous if you are a basic rate taxpayer, so long as the refunds are not large enough to take you over the threshold for higher rate tax.
Compensation that would cause a chargeable event is not taxable if it, and any other repayments out of the policy, do not exceed a set limit. That limit is 5% of the total premiums paid for the policy for every year the policy has been held. So if you took out a life insurance policy for a single premium of £10,000 you could receive refunds of up to £500 per year tax-free and that allowance is cumulative: so if you received £1,500 after holding the policy for three years and making no withdrawals, the compensation would be covered by permitted withdrawals and would not be taxable.
If the compensation is paid without reference to an existing insurance policy, it will usually be covered by HMRC’s policy of not taxing compensation up to £500,000, and not many people will receive such a large sum for financial mis-selling.
Interest
Interest received on mis-sold financial products can lead to unfortunate results. The problem is that interest is taxed as and when it is received, regardless of how many years have passed since the mis-selling that gave rise to the claim.
Practical Tip :
More people pay tax on interest than compensation, and much compensation is only liable to higher rate tax. Therefore if you have the choice it will often make good sense to take an offer of an enhancement of an existing policy so that there is no interest and instead the payment for lost income over time is rolled up into the growth on the policy.
