In James Allan Thornton v HMRC  UKFTT 767 (TC), the First-tier Tribunal (FTT) considered the distinction between income and capital payments in the context of a settlement relating to rental property and held that a settlement payment made to a landlord as compensation for dilapidations to his property was a capital receipt.
James Allan Thornton (the taxpayer) was a sole trader who owned 18 flats, known as Jordan House, Nairn (the property). The property had been the subject of a single lease. Payments in respect of the lease were paid into the taxpayer's bank account for his personal benefit.
The lease contained clauses concerning the repair and upkeep of the property for which responsibility lay with the tenants. However, the tenants had failed in their obligations and the property had become uninhabitable and, according to the taxpayer, ‘dangerous’.
Although the tenants continued to pay rent under the terms of the lease, the property had been vacant for over a year and the taxpayer became anxious to regain possession to enable him to prevent the further dilapidation of the property and he began negotiations with the tenants.
Following assessment by surveyors, the taxpayer sought a settlement payment in excess of £300,000 to reflect both the dilapidations and also a payment referable to a discounted rate of rent.
The sum eventually agreed was £250,000. There was no particularisation of this sum, it was, so the taxpayer maintained, a compromise intended to bring the matter to a close.
The taxpayer used the money he had obtained to repair the building. The sum expended on the renovations far exceeded the £250,000 he had obtained in settlement and at the time of the tribunal hearing the repairs were ongoing. It was only after ten months or so that some of the flats were in a fit state to let. With a further section of the property let some 18 months later.
The dispute between HMRC and the taxpayer concerned the treatment of the £250,000 settlement sum. The taxpayer treated the £250,000 as a capital payment which he used to repair the property and thereby safeguard his capital investment.
HMRC argued that the settlement was income because it covered the loss of rental income, albeit due to the dilapidated state of the properties and issued a discovery assessment to the taxpayer on that basis. The taxpayer appealed to the FTT.
In allowing the taxpayer's appeal, the FTT considered not only the background of the lease, from which HMRC derived its argument that the full sum of settlement must have been attributable to rental payments and must therefore be income, but also the circumstances surrounding the negotiations. In particular, the FTT noted the taxpayer’s concern to regain possession as soon as possible and that this had led him to accept a significant reduction in the settlement which was ultimately agreed.
The FTT was of the view that the taxpayer's had, in effect, agreed to forgo rental payments when agreeing the final settlement sum. Accordingly, the FTT found that the whole of the settlement related to the costs of repairing the dilapidations and should be treated as capital rather than an income receipt.
A considerable body of case law has built up on the difficult question of when a payment constitutes an income or capital receipt, particularly in the context of settlement payments.
Each case will of course turn on its own particular facts, but parties in settlement negotiations should pay close attention to the precise nature of the terms of any settlement reached, which should be carefully documented so that in the event of a challenge by HMRC to the nature of the settlement payment, sufficient contemporaneous documentary evidence is available to substantiate the true nature of the payment.
HMRC often seek to re-characterise settlement payments so that a there is a greater tax charge than would otherwise be the case, and changes to its guidance in this area in recent years suggests that this is an area in which HMRC is likely to take a more aggressive stance in the future.
This case acts as a reminder that such re-characterisations can be successfully challenged.
A copy of the decision can be found here.