Tax Treatment of Damages: How Does it Work? (Europe)

This Quick Overview focuses on the tax treatment of damages through the study of direct and indirect taxation.

Direct taxation of damages: income tax

Let us consider taxation of damages both from the payer's (1) and the recipient's (2) point of view. “ From the payer's point of view This section will deal with enterprises only, as an individual will generally not be allowed to deduct any paid damages from his/her tax base. Tax payers will have the possibility to deduct paid damages relating to the normal course of business (1.1) but not related to fines and penalties (1.2). 1.1 Deductibility of damages linked to the normal course of business Damages paid by an enterprise are generally deductible from the tax base when they are directly linked to the normal course of business or to any work carried out by an employee in the performance of his/her duties.

For instance, damages paid by an employer to an employee in case of unfair dismissal will generally be a deductible expense. Damages paid for breach of copyright or trademark would also be considered as deductible expenses if these were used to promote the company's business. 1.2 Non-deductibility of paid damages relating to fines and penalties Pursuant to Article 39 §2 of the French Code Général des Impôts, fines and penalties are not deductible. The United Kingdom takes on the same approach: a fine resulting from an infraction of the law is not tax deductible on the authority of CIR v Alexander von Glehn Ltd case (House of Lords, 1920, case 12TC232). According to Lord Hoffman in McKingh v Shepard case (House of Lords, 1999, case 71TC419), the purpose of a fine "is to punish the taxpayer, and a court may easily conclude that the legislative policy would be diluted if the taxpayer were allowed to share the burden with the rest of the community by reason of a deduction for the purposes of tax." 2 – From the recipient's point of view

2.1 Taxation of damages received by an enterprise Basically, damages are taxable when they compensate losses of taxable income, losses or expenses deductible by nature, or the loss or depreciation of assets. Taxable income refers to revenue linked to commercial or industrial operations and, more generally, to the enterprise's normal business. For instance, in France, damages that compensate a breach of contract (Conseil d'Etat, February 7, 1944, case 70316) or unfair competition are taxable as they compensate a loss of taxable income. If part of the received damages for a loss of income compensates a loss of clientele, they are also taxable (Conseil d'Etat, June 19, 1974, case 92092). However, when they are not associated with a loss of income, damages compensating a loss of clientele are not taxable. These damages must be included in the taxable income of the fiscal year of the court decision. Damages compensating a prejudice generating non-deductible expenses or losses are not taxable themselves. 2.2 Taxation of damages received by an individual In general, damages compensating a temporary loss of income are taxable whereas damages awarded to compensate physical injuries or moral damages are generally exempt. For instance, Article 7 d) of Spanish Ley del Impuesto sobre la Renta de las Personas Físicas provides that damages accorded by a court are exempt of taxation under the condition that they derive from civil liability for "personal harms". The Spanish State Agency of Tax Administration interprets "personal harms" as a broad notion including physical, psychological and moral harm. However, some limits may exist under national rules. In France, if the amount of damages for moral prejudice exceeds one million euros, they will be taxable in accordance with article 80 of the French Code Général des Impôts.

Indirect taxation of damages: Value-Added Tax

With respect to indirect taxation, the first question to be considered is whether the damages are subject to VAT (1), which leads to the question of refund of VAT upon damages (2). 1 - Question of taxation of damages under VAT Within the European Union, VAT is applicable to supply of goods, intra-EU acquisition of goods, importation of goods and supply of services (Council Directive 2006/112/EC - November 28, 2006). As a consequence, the rule is that damages punishing non-performance of an obligation or prejudice to any interest do not fall within the scope of VAT. However, damages can be subject to VAT when they represent a compensation for a taxable operation, namely a performed service or a supply of goods. To determine if damages are subject to VAT, two conditions must be met pursuant to the Apple & Pear case (ECJ, March 8, 1986): - The transaction must be individualized and confer an advantage to the beneficiary, and - The paid price must be in return of the supply of goods or services. Consequently, damages allowed by court decisions that compensate a supply of goods or services shall be taxable under VAT. Damages that aim at insuring the financial balance of a contract are subject to VAT (Conseil d'Etat, Polyclad, December 15, 2000) but when they only compensate a damage suffered by the beneficiary, for instance in case of unilateral termination of a contract, they are not taxable under VAT (Conseil d'Etat, Magnetti Marelli, May 28, 2004). For instance, in the case of a service contract, if the service had begun to be provided, damages allowed by the court shall be distinguished between those compensating the suffered prejudice and those compensating the partially provided service. On the contrary, if the damages represent the compensation of a common commercial wrong, they are not subject to VAT since they do not compensate a supply of goods or services. 2 - Question of deductibility of VAT upon damages In the European Union, for the VAT to be refunded, an invoice must be established or any equivalent document containing the required legal stipulations of an invoice as set in Directive 2008/09/EC, February 2008. Considering a court decision as an ‘equivalent document' depends on the legal traditions of Member States. For instance, in Italy and Spain, case law is very strict on this point and requires an invoice in addition to the court decision. However, in the UK and in the Netherlands, the court decision could be considered as an ‘equivalent document' sufficient to recover VAT. From a European point of view, in the Petroma Transports SA vs Etat Belge case (May 8, 2013), the ECJ established the refusal of the right to deduct input VAT in the absence of an accurate or proper VAT invoice. In France, professionals recommend that the VAT explicitly appears on the court decision. The words ‘tax included' are not sufficient to determine the VAT amount. The document shall also comply with the other requirements of article 289 of the French Code Général des Impôts which are, non-exhaustively, identification of both parties, numbering of invoice, date, addresses and individual numbers of VAT.

Conclusion

Tax treatment of damages depends on national jurisdictions. Generally, damages will be directly taxed where the loss that they compensate would have been taxable. Consequently, litigators may take this tax aspect into account to calculate the amount of damages they will ask for. Furthermore, if the court does not explicitly state the VAT amount related to the awarded damages in its decision, issues may arise both for payers and receivers. The beneficiary would consider that VAT is not included in the amount of damages whereas the payer would claim the opposite. Therefore, the best way to prevent risks relative to tax treatment of damages would be to ask the court to explicitly address this matter.

Additional resources

- Bulletin Officiel des Finances Publiques - Impôts, accessible at: http://bofip.impots.gouv.fr/bofip/1-PGP.html - Internal Revenue Service, 'Lawsuits, awards, and settlements audit - Techniques guide', May 2011, accessible at: https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Lawsuits-Awards-and-Settlements-Audit-Techniques-Guide - CHANH S., ‘Le régime fiscal des indemnisations', December 2006, accessible at: https://www.ffsa.fr/webffsa/risques.nsf/html/Risques_68_0017.htm - Collectif Francis Lefebvre, ‘Mémento pratique – fiscal 2015', Editions Francis Lefebvre, March 2015 - Mc CARTHY H., ‘The tax treatment of damages and compensation', Private client business, Thomson Reuters UK Limited, 2012 - Her Majesty's Revenue & Custom accessible (HMRC), collection of taxes department of the UK government, accessible at: https://www.gov.uk/government/organisations/hm-revenue-customs