In James Allan Thornton v HMRC, the First Tier Tribunal (FTT) was asked to determine whether settlement monies received by a landlord for the termination of a lease should be taxed as income or capital.

Mr Thornton was a sole trader and the owner of 18 flats which he let to a single tenant. The flats fell into disrepair and became uninhabitable as a result of the tenant's failure to maintain them.

Mr Thornton became anxious to recover the flats as quickly as possible to prevent any further damage and agreed to enter into negotiations with the tenant to terminate the lease. After lengthy negotiations, Mr Thornton accepted a £250,000 payment in settlement. The £250,000 was described under the settlement as being "in full and final settlement in relation to all issues associated with the lease".

The settlement money was reinvested by Mr Thornton into the flats as extensive work was undertaken to repair the damage. He did not enter the £250,000 into his business' profit and loss account but instead made an entry in its balance sheet as a creditor.

The following year, after commencing an investigation into Mr Thornton's tax return, HMRC assessed Mr Thornton for tax on the basis that the settlement constituted an income receipt to the business for the loss of rental income caused by the dilapidated state of the flats.

Mr Thornton appealed against HMRC’s assessment and argued that the £250,000 should be treated as a capital receipt. The money was, he argued, used to repair the damage done to the properties and for preserving his capital investment. Mr Thornton did concede that a figure for six months’ rent had been discussed as part of the negotiations but that this had not been included within the final agreed amount.

The question before the FTT was therefore how much of the settlement money was attributable to rent? Finding in favour of Mr Thornton, the FTT held that none of the settlement should be attributed to rent. Mr Thornton had been so desperate to recover his flats that he had implicitly agreed to waive any future rental payments and, as the whole settlement had been invested in repairing the flats, there was nothing left which could be considered income from loss of rent.

This is a helpful case on the treatment of payments into a business and what can often be a fine distinction between income and capital payments. The lesson to take away from this is the importance of properly documenting all payments into and out of your business. Had the paperwork clearly dealt with the settlement and the basis on which it was paid, fewer questions would have been raised over its tax treatment and the possibility of HMRC challenging the return would have been less.