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- common problems in resolving mortgage underfunding cases transitional arrangements for insurance intermediaries is compensation taxable?ask ombudsman news

Walter Merricks, chief ombudsman

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ombudsman news gives general information on the position at the date of publication. It is not a definitive statement of the law, our approach or our procedure.

The illustrative case studies are based broadly on real-life cases, but are not precedents. Individual cases are decided on their own facts.

ombudsman news

issue 43

February 2005

is compensation taxable?

This article is based on a technical briefing note, published on our website. It explains, in broad terms, our understanding of some general principles relating to the tax treatment of any compensation that we award. In particular it deals with:

compensation in mortgage endowment cases
compensation for being deprived of money
compensation for investment loss
compensation where an account is reconstructed.

The exact tax treatment of the compensation awarded to any individual consumer is likely to depend both on the circumstances of the case and on the consumer’s own wider financial and tax position. This is not something the Financial Ombudsman Service can advise on. Ultimately it is a matter to be resolved between the individual consumer and the Inland Revenue.

compensation in mortgage endowment cases

Where we uphold mortgage endowment complaints, we usually require the firm to put consumers in the position they would be in now if they had originally taken out a repayment mortgage instead of the endowment mortgage. Our approach to redress in these cases follows the guidance in the Financial Services Authority’s handbook (DISP Appendix 2 – often still referred to as ‘RU89’ by some in the industry). Payment of compensation calculated in this way is unlikely to create any liability to income tax or capital gains tax. But surrendering or selling the endowment policy may trigger a gain that may be taxable. The firm will then usually be liable to refund any tax (under DISP Appendix 2, paragraph 2.5.9G).

compensation for being deprived of money

The following are examples of compensation in cases where we uphold a complaint that the consumer has been deprived of money.

an insurance company wrongly refused to pay out on Mr A’s insurance claim. We required the insurance company to pay Mr A’s claim, plus interest on the claim to the date of payment.
a bank did not pay Mrs B the proceeds of her investment until June, even though the investment had matured in January. We required the bank to pay Mrs B interest on the proceeds from January to June.
Mr C was not in a position to invest, but an investment company wrongly persuaded him to pay into one of its investment policies. We required the investment company to cancel the policy from the beginning and to refund Mr C’s contributions with interest.

In cases like these:

the compensation we award is for being deprived of money. As in the examples above, this is usually interest until the date the money is paid.
this part of the compensation is potentially subject to income tax, even if it is not described as interest. Usually the law requires a firm to deduct income tax at the basic rate from such compensation – and to pay this to the Inland Revenue. This is to prevent tax evasion.
if the consumer is not liable to income tax at the basic rate, they can reclaim the deducted income tax from the Inland Revenue. In order to help the consumer reclaiming the tax deducted, where relevant, the firm is required to provide the consumer with a certificate of tax-deduction.

compensation for investment loss

Where we award compensation for an investment loss – typically because the consumer was put in the wrong product or account – the tax position depends on whether the consumer still has the wrong product or account

a) where the consumer still has the product/account The following cases are examples of compensation where we uphold complaints that the consumer was put in the wrong investment or account, which the consumer still has.

Miss D was planning to invest but had no particular investment in mind. An investment company wrongly advised her to take out an unsuitable investment – which then lost money. We required the investment company to pay Miss D what her investment would have been worth if the capital had grown at 1% a year above Bank of England base rate, less the current value of the unsuitable investment.
Mr E was planning to take out investment X, but a financial adviser wrongly persuaded him to take out an unsuitable alternative investment – Y – which performed worse. We required the financial adviser to pay Mr E what investment X would have been worth, less the current value of the unsuitable investment - Y.
Mrs F had money in her deposit account with a bank. The bank wrongly persuaded her to move the money into an unsuitable investment which then lost money. We required the bank to pay Mrs F what her money would have been worth if it had been left in the deposit account, less the current value of the unsuitable investment.

In cases like these:

the compensation we award is for investment loss. As in the examples above, this is usually based on what would otherwise have happened to the consumer’s money.
this kind of compensation is not usually subject to income tax, even if it is calculated by reference to an interest rate. And the law does not require a firm to deduct income tax at the basic rate.
the consumer may be liable to pay capital gains tax on it. Whether or not capital gains tax is payable will depend on the consumer’s individual circumstances. The law does not require firms to deduct capital gains tax from such compensation.

b) where the consumer no longer has the product/account

The following cases are examples of compensation where we uphold complaints that the consumer was put in the wrong investment or account, which the consumer no longer has.

Miss G was planning to invest but had no particular investment in mind. An investment company wrongly advised her to take out an unsuitable investment - which then lost money. To reduce her loss, Miss G cashed in the unsuitable investment a year ago. We required the investment company to pay Miss G:
- her loss (calculated as what her investment would have been worth a year ago if the capital had grown at 1% a year above Bank of England base rate, less the sale price of the unsuitable investment); plus
- interest on that loss from the date the unsuitable investment was cashed in until the date the compensation was paid.
Mr H was planning to take out investment X, but stockbrokers wrongly persuaded him to take out an unsuitable alternative investment - Y - which performed worse. The unsuitable investment matured a year ago. We required the stockbrokers to pay Mr H:
- his loss (calculated as what investment X would have been worth a year ago, less the maturity value of the unsuitable investment - Y); plus
- interest on that loss from the date the unsuitable investment matured until the date the compensation was paid.

In cases like these:

the tax treatment of the two parts of the compensation is likely to be different.
the compensation for the investment loss to the date the unsuitable investment was sold (or matured) is not usually subject to income tax - in the same way as explained in section 3(a) above.
the compensation for being deprived of the investment loss from the date the unsuitable investment was sold (or matured) is potentially subject to income tax - in the same way as explained in section 2 above.

compensation where an account is reconstructed

The following cases are examples of where we require firms to reconstruct an account.

a building society temporarily mislaid two of the mortgage repayments that Mr and Mrs J had made. We required the building society to reconstruct Mr and Mrs J's mortgage account, so that the interest was adjusted to what it would have been if the repayments had been credited at the right time.
a bank agreed an increased overdraft for Mr K, but forgot to update its computer system. The computer system treated the increased overdraft as unauthorised, and applied a higher rate of interest and charges. We required the bank to reconstruct Mr K's account, so that only the correct interest and charges were applied.

the tax position will be based on the account as reconstructed - and will be the same as if the firm had never made the error.