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Shop shock
Shop shock
Ralph has a shop in a major city centre, for which he originally acquired a lease from the freeholders who were a property investment company. On expiry of the lease, Ralph placed the matter in the hands of his solicitors to negotiate terms for a new lease, but, unfortunately due to an error on the part of the solicitors, certain time limits went by without appropriate action so that Ralph lost valuable renewal rights in relation to his occupation of the premises. As a result, he had to agree much less favourable terms for his new lease, involving payment of higher rent.
Ralph has made a claim on his solicitors for compensation, which has been agreed in principle. What will the tax treatment of the compensation be?
(Query T16,147) City Centre.
To consider the nature of the proposed compensation, which is taken to relate to the trade in question, it is first necessary to determine as to whether it is capital or income. One therefore has to ask what the compensation was actually for. Ralph's current position is that under the terms of his new lease he is paying a higher rent than would have been the case if the solicitors had not made the error regarding the time limits concerned. Therefore, the claim on Ralph's solicitors is in effect arranging for them to make up the difference so that over the period of the new lease he will be no worse off, as to the amount of rents paid. Under section 18(1), Taxes Act 1988, the compensation therefore appears to be of a trading income nature and, because it will be liable to tax, will be paid gross. It will fall in the income and expenditure account as a receipt that is netted off against the rents paid, leaving the same allowable deductions as if the error had not been made. Cases in which payments were made to compensate a trader for loss of profit and so be treated as a trading receipt were Lang v Rice 57 TC 80 and Donald Fisher (Ealing) Ltd v Spencer [1989] STC 256.
A guideline to this argument can be found in the Revenue's Capital Gains Manual at paragraphs 12041 to 12052, in respect of comments on Zim Properties Ltd v Proctor [1985] STC 90. The most obvious remark appearing under paragraph 12046 is: 'In any case involving a right of action, it is necessary to determine the full facts, including all the available documents, to establish whether you are dealing with a statutory right, a contractual right, or a Zim style right'.
The only other point of interest is as to the size of the compensation, because of the period to which it relates. The length of Ralph's new lease has not been mentioned, and so one would think that there might be a problem caused by netting off the compensation against the rent paid in the accounts of the period of receipt. However, in paragraph 366 of the Inspector's Manual this matter is covered: 'Reimbursement of trading expenses Where an amount of compensation, not itself a trading receipt under paragraphs 362 to 365, includes reimbursement of trading expenses that are admissible as a deduction, such expenses should be treated as diminished to the extent of the reimbursement (see the dictum of Lord Blackburn in Commissioners of Inland Revenue v Granite City Steamship Co Ltd 13 TC at page 18). If such diminution is effected in the trader's accounts by crediting the reimbursement when received, no objection need normally be raised to that course being followed for tax purposes'. N.K.
There are two key cases dealing with this type of compensation sum, namely Tucker v Granada Motorway Services Ltd [1979] STC 393 and Donald Fisher (Ealing) v Spencer [1989] STC 256. In the Tucker case a lump sum, payment was made to relieve the company of future onerous payments and effectively change the nature of the lease. The House of Lords held that the payment was capital because it had improved the lease.
In the case of Donald Fisher (Ealing), an agent acting for the company failed to serve a notice which resulted in an amount of damages payable by the agent of £14,000. It was held that the amount received by the company was not for an amendment or modification to the lease, but caused additional rent to be paid over the next five years. The conclusion was that the damages received were taxable as income and not capital.
It would seem from details given in 'City Centre's' query that the failure by the solicitors has affected directly the terms of the new lease. Although a higher rent has also resulted, the facts would appear to be much closer to those in the Tucker case, thus rendering the compensation capital rather than income. Wilwok.
Editorial note. A majority of those respondents applied the Donald Fisher (Ealing) case, but that case involved a rent review during the currency of a lease. Here a distinguishing factor is that the payment can be seen as compensation for the destruction of an asset, the former renewable lease. Arguably, the payment is capital and the compensation should be grossed up to cover any capital gains tax liability.
