When it comes to the amount of damages that may be awarded to a Plaintiff, taxation is not always applicable (for example, compensation on damages for personal injury awards is exempt from tax).
However, where taxation does apply, the damages required to restore a Plaintiff to their original position can easily be miscalculated.
We are seeing this situation arise in relation to losses associated with ill-fated investments, where instead of having regard to the composition of the loss, the full amount of the loss is grossed up without considering the taxable and nontaxable elements.
What is grossing up?
Grossing up is a business term that refers to a payment that has some type of compensation for taxes built into it.
Why is it relevant?
The fundamental principle of compensation means that the damages to be recovered are in money terms no more and no less than the Plaintiff’s actual loss.
In relation to a payment for poor financial advice, the payment needs to be grossed up for any taxation that may apply so the injured party is put in the same after tax position as they would have been but for the financial advice being implemented.
The quantum of such taxation liabilities depend on the composition of the damages awarded.
How should this be done?
Generally, the components of the amount awarded are either revenue or capital in nature.
For investments, the damages awarded to a Plaintiff may need to be grossed up for taxation purposes where the Plaintiff has previously claimed a tax deduction i.e. on the holding costs incurred.
In contrast, a taxpayer does not claim a deduction for the capital component of their investment. Rather, the receipt of compensation for the Plaintiff’s capital losses is unlikely to trigger a capital gain as the compensation generally will not exceed the capital loss experienced by the Plaintiff.
Thought must also be given to the character of the additional payment to the Plaintiff which compensates them for the taxation they will pay on the holding costs.
What happens if you get it wrong?
Where applied incorrectly, the grossing up of damages can make a material difference to the amount an Insurer has to pay the Plaintiff.
In one instance we observed the overcompensation of the Plaintiff was up to 25% of the claim.
What should you look for in the Expert’s report?
If you have received an Expert’s report where the damages to be awarded are subject to tax, consider whether the Expert:
- Recognises the taxable and non-taxable elements of the award;
- Has regard to the timing of the payment of the taxation;
- Identifies whether the Plaintiff can access Capital Gains Tax Concessions;
- Uses a range or average of marginal tax rates that have been paid over several years.