Compensation payments derived from mis-selling are taxable income
The Upper Tribunal (UT) has reaffirmed that the tax treatment of compensation is strictly governed by the legal nature of the original loss, ruling that theoretical economic concepts like “opportunity cost” cannot be used to recharacterise taxable revenue refunds as non-taxable capital receipts (NCRs).
Facts:
In 2006, the Hackett brothers purchased several complex financial products from HSBC and RBS to manage potential interest rate fluctuations on their bank loans. While these products protected against rising rates, they included a “floor” that required the appellants to make substantial payments to the banks when interest rates fell below a certain level. Following a drop in base rates in 2008, the appellants incurred high costs through their adoption of these products, which they properly deducted as business expenses when calculating the profits of their property rental business for tax purposes.
Starting in 2010, the Financial Conduct Authority (FCA) identified widespread mis-selling of these products and established a redress scheme. Under this scheme, the banks agreed to provide “basic redress” to customers, which was intended to put them back in the position they would have been in had the regulatory failings not occurred. For the Hacketts, HSBC determined that, while they would have required some protection, they should have been sold simpler “cap” products rather than the complex “cap and floor” versions they received. Consequently, the bank paid the appellants approximately £1m in basic redress, calculated as the difference between the payments actually made under the mis-sold products and the payments they would have made under the simpler alternative products.
The dispute arose when HMRC issued closure notices amending the appellants’ 2014-2015 tax returns to treat these redress payments as taxable income. The Hacketts appealed this decision to the First-tier Tribunal (FTT), arguing that the compensation was not a refund of expenses but rather a non-taxable receipt for an “opportunity cost”.
Decision:
The UT dismissed the appeal, ruling in favour of HMRC. The Court confirmed that the compensation payments received by the Hackett brothers constituted taxable income rather than NCRs.
The UT applied the established legal test from Attwooll and Deeny and reasoned that if a payment is made to replace a sum that would have been taxable as income, the compensation itself must be treated as income.
The most significant part of the UT’s reasoning was the distinction between accounting costs and economic opportunity costs. The Court held that, while the notion of an “opportunity cost” is a valid concept for economists, it does not exist in the world of tax and accounting. The appellants argued that because the redress aimed to put them in the position they would have been in “but for” the mis-selling, the payment was for the “lost opportunity” to have a better product. The UT rejected this, stating that the method of calculation does not change the nature of the payment
Implications:
This case confirms the legal boundary between economic theory and tax law. The Court has made it clear that opportunity cost is not a tax-deductible or tax-exempt category. The case reinforces a fundamental rule: the tax treatment of compensation follows that of the original loss.
The Court drew a hard line between economic theory and legal accounting reality, as the law only recognises “realised” events. Thus, the notion of “theoretical value” cannot be used to change the tax status of what was actually done. This rule limits the ability of taxpayers to use complex economic models to bypass simple tax rules.