THE TAXATION OF EQUITABLE COMPENSATION
Richard Wilson considers the way in which tax is charged equitable compensation
paid by a trustee in recompense for a breach of trust or other equitable duty
(taken from Issue No 18 – January 2002)
The first question to be answered is ‘what is meant by equitable compensation?’ This is a question to which there is no easy answer, and certainly no definitive answer of a length appropriate to a short article such as this. The briefest definition which can be provided is that equitable compensation is ‘a loss based remedy for breach of an equitable duty’. However this definition requires further explanation.
Equitable compensation is loss-based. This must be contrasted from what might be termed ‘restitutionary’ remedies. The prime example of a restitutionary remedy is the account of profits. Thus where a fiduciary makes an unauthorised profit, equity can compel him to account for that profit1. The account of profit does not require any loss to have been sustained by the person to whom the fiduciary duty is owed. Compensation on the other hand is a remedy which compensates for the loss sustained. Thus where in breach of trust a trustee invests in an unauthorised investment, and a loss is sustained as a result, the trustee is required to pay a sum in compensation to restore the trust fund to the level it would have been had he not breached his duty2. In certain contexts, equitable compensation has been referred to as ‘restitutionary’. However it is restitutionary only in the sense that it is the means whereby the trustee restores the trust fund to the level it would have been had he not breached his duty, and as such is truly compensatory in nature.
In this article I do not deal with the question of the impact of taxation on the calculation of equitable compensation (i.e. the impact of the Gourley principle3) This issue arises only when the receipt of compensation is free of taxation. The issue under consideration in this article is the incidence of tax on sums paid by way of compensation.
Capital Gains Tax
A charge to CGT arises where a person makes a disposal of assets4. The question to be answered in this context is therefore whether the payment of equitable compensation by a trustee or other fiduciary involves a ‘disposal of assets’. The payment of compensation is not a straightforward disposal in the way that a sale of an asset is, but a disposal for CGT purposes also takes place where a capital sum is derived from assets, notwithstanding that no asset is acquired by the person paying the capital sum5. It must therefore be determined in each case where compensation is paid whether the compensation payment made derived from assets, and consequently within the scope of the charge to CGT.
A straightforward example of a case in which the payment of a capital sum is derived from an asset is as follows: a trustee negligently fails to care for trust property, which is not insured. The property is damaged beyond repair and is therefore worthless. By his omission to take reasonable care of the trust assets, the trustee is in breach of his equitable duty of care and skill, and therefore liable to pay compensation by making good the loss on the taking of an account. Such payment of compensation is clearly ‘derived from’ the trust asset, in that it is paid in order to replace the asset which as a result of the trustee’s negligence is of no value. Indeed, it is easy to see why, as a matter of principle, this should be so: in effect the trustee has replaced an asset held upon the trust with the monetary value of the asset. Whilst the cause of this conversion from physical asset into money is different from the case of a sale of the asset, the result is the same.
Where the receipt of a capital sum does fall into charge by virtue of s.22 TCGA 1992, fairness is ensured to some extent by permitting the recipient to deduct from the compensation received an appropriate proportion of the allowable expenditure in relation to the asset. Therefore if the value of an asset is reduced by, say, 50%, that percentage of the acquisition cost and other allowable expenditure in calculating the gain for CGT purposes arising on the part disposal6.
The position is mitigated to some extent by the operation of s.23 TCGA 1992 which provides that where a capital sum is received by way of compensation, and is derived from an asset which is neither lost nor destroyed; if the recipient may claim relief under that section, thereby ensuring that the receipt is not treated as a disposal provided one of the following conditions is satisfied. The conditions are that
(a) the capital sum is wholly applied in restoring the asset7; or
(b) the capital sum is applied in restoring the asset except for part of the capital sum which is not reasonably required for the purpose and which is small compared with the whole capital sum8; or
(c) the amount of the capital sum is small, as compared with the value of the asset9.
Thus, using a more specific form of the example referred to above, where a trustee fails to ensure that a trust asset, such as a valuable painting is kept in appropriate storage, and the painting’s condition deteriorates, the compensation payable by the trustee, in respect of the decrease in value caused by his neglect, will not be treated as a disposal for CGT purposes, if he makes the appropriate claim under s.23, and the compensation (or at least all except that part which is not reasonably required for that purpose and is small compared with the value of the asset) is used to restore the painting, or if the amount of the compensation is small as compared with the value of the painting. There is no clear guidance provided as to what is ‘small’ in this context, which is a question of fact and degree.
Further, where an asset is lost or destroyed, and the compensation is applied in the purchase of a replacement asset, s.23 (4) provides that the recipient of the compensation may make a claim for relief whereby the disposal of the so-called ‘old asset’ is treated as taking place for a consideration at which no gain or loss takes place, and the acquisition cost of the ‘new asset’ is taken to be reduced by the excess of the compensation received over the amount at which the old asset is treated as having been disposed. The operation of the relief is, perhaps, more easily exemplified than explained. Again, let us take the example of a painting held as a trust asset, but which by virtue of the trustee’s failure to take reasonable care and skill and store it properly, is destroyed. Assuming (ignoring both indexation and taper relief) that the purchase price of the painting was £10,000, but at the time of destruction it was worth £15,000, the trustee would be required to pay compensation in the sum of £15,000. If s.23(4) relief is successfully claimed, the old asset will be treated as having been disposed of for £10,000, and any new asset purchased for, say £20,000, would have its acquisition cost reduced by £5,000, representing the excess of the sum received as compensation (£15,000) minus the deemed disposal value (£10,000).
A capital sum is ‘derived from assets’ in wider circumstances than in what might be termed the ‘direct’ case set out above (e.g. where a trust asset is damaged or destroyed, or is otherwise diminished in value) for example, in cases where compensation is paid as a result of a court action or the negotiated settlement of such an action, as a result of the decision in Zim Properties v. Proctor10. In Zim, the claimant company contracted to sell three properties. A completion date was fixed, but completion did not take place on the appointed date due to the loss of one of the original conveyances. As a consequence the sale fell through, and the deposit was returned to the prospective purchasers. The claimant company sued its solicitors for damages to compensate them for the loss they had sustained. The claim was compromised with the solicitors paying a sum to the company. The Revenue sought to charge the payments to tax as a chargeable gain, and succeeded before both the Special Commissioners and the High Court. The basis for the decision was that the capital sum received by the company was derived from an asset – not the properties that the company owned – but the right of action the company had against its solicitors.
The impact of Zim is clearly considerable: in principle any right of action is an ‘asset’ for the purposes of CGT and the derivation of any capital sum therefrom may constitute a disposal by virtue of s.22. Consequently, capital sums received by way of equitable compensation for a whole host of equitable wrongs are capable of being subjected to CGT (but see below in relation to the effect of Extra Statutory Concession D33). Further, unlike the situations in which a tangible asset is damaged or destroyed, there is no allowable expenditure to be brought into account in calculating the gain.11
But perhaps more crucially, by treating a right of action as an asset in itself, Zim creates a problem in relation to claims for compensation brought in respect of damage to a tangible asset. By the logic applied in that case, if a sum is paid in settlement of a claim, the capital sum derives from the right of action and not from the asset itself. Consequently there is no allowable expenditure, even though the asset itself may have been destroyed. It is, of course, open to question whether a beneficiary has a cause of action in the Zim sense when calling a trustee to account in respect of trust assets. One view is that the trustee is simply prevented on the taking of an account from asserting that the asset in question (or its equivalent value whether in the form of money or an alternative authorised investment) forms part of the trust fund12. However, this issue is of more academic than practical importance due to the provisions of ESC D33. That concession provides that where the cause of action derives from an asset, the allowable expenditure (or the appropriate percentage thereof) may be deducted from the proceeds when computing the gain.13
ESC D33 is also of considerable importance in relation to the receipt of equitable compensation where there is no underlying asset. As discussed above, the receipt of such compensation constitutes a disposal of the underlying right of action. Therefore in a case where, for example, a fiduciary breaches his duty of confidentiality and is required to pay compensation therefor there is prima facie a liability to CGT on the sum received. However, paragraph 11 of ESC D33 provides that such sum is in fact exempt from CGT.
Of course, CGT is relevant to the payment of compensation only where the receipt is of a capital nature. Different considerations will apply where the sums received by way of compensation are of an income nature. Where such compensation can be shown to be of an income nature, then it will be subjected to the rules governing income tax and not CGT. In broad terms a receipt of compensation will be income where it replaces sums which would have been income such as lost profits14. Consequently, where a fiduciary is required to compensate for lost income, that compensation will be taxed on basic income tax principles in the same way as the income itself would have been, subject to any specific exemptions which might apply.
Therefore, in principle, in a case where a trustee pays compensation to a life tenant in order to rectify a failure to act fairly as between him and the capital beneficiaries (e.g. by investing in high capital return investments which produce no income) the receipt of such compensation by the beneficiary should be taxable in the same way as any payment of trust income would have been. It is clear that the taxation of income compensation has the benefit of being far more straightforward than the taxation of capital compensation.
The main Inheritance Tax (‘IHT’) aspects of equitable compensation relate primarily to the timing of the receipt of the compensation. Let us consider the situation where a trustee breaches his duty towards a beneficiary who is, or is treated15 as being beneficially entitled to the trust fund. During the life of that beneficiary, the trustee committed a breach of trust that went undetected until after the beneficiary’s death. Eventually the beneficiary’s personal representatives bring a claim for compensation against the trustee and recover such compensation from him. The question which must be asked is whether the value of the compensation should be subject to IHT as part of the deceased beneficiary’s estate on death? The justification for including it is that if one considers the CGT analysis in light of Zim the right to recover compensation is an asset with value. That asset formed part of the deceased’s estate upon his death and in principle should be subject to IHT. However in practice IHT is often not sought by the Revenue in respect of the value of compensation received by a deceased’s estate. Further, in Re: Bell’s Indenture16 when the Revenue indicated that they would not seek IHT on a payment of compensation, the defaulting trustee was still required to pay the gross amount as opposed to a net amount taking into account the tax which would have been payable had the trustee carried out his duties properly.
9 Stone Buildings
1 See, for example, Phipps v. Boardman  2 AC 46.
2 I recognise that the way in which this example is put may be controversial. Many describe the payment made by the trustee in such circumstances as a falsification of the account, and eschew the terminology of compensation. It is my view, however, that such a falsification is truly compensatory in nature and therefore properly described as equitable compensation for the purposes of this article.
3 BTC v. Gourley  AC 185
4 4 s.1(1) Taxation of Chargeable Gains Act 1992.
5 See in particular, s.22(1)(a) TCGA 1992
6 s.42(2) TCGA 1992
7 s.23(1)(a) TCGA 1992
8 s.23(1)(b) TCGA 1992
9 s.23(1)(c) TCGA 1992
10  STC 90
11 Other than legal or other professional costs. See ESC D33, para 2.
12 See Sir Peter Millett (as he then was) `Equity’s place in the Law of Commerce` (1988) 114 LQR 214.
13 ESC D33, para.9
14 See London & Thames Wharves v. Attwooll  Ch. 772.
15 By virtue of s.49 IHTA 1984, for example.
16  3 All ER 425