Is an award of damages, including loss of past and future earnings taxable in Malta?
Article 4(1)(g) of the Income Tax Act is a catch-all provision which charges to tax any other income not covered in 4(1)(a) to 4(1)(e). Thus as a consequence this gives rise to a situation where all income is taxable. This sweeping up clause covers those instances where the taxpayer is earning income from a specified source, which is not provided for in Article 4. This sub-article is a convenient generalized source, since as a principle in tax matters, no income arises unless there is s specified source.[1]
Article 12(h) provides an exemption from income tax imposition on any capital sum received as consolidated compensation for death or injuries. An award of damages for permanent disabilities would reflect the reduced income earning capacity of the injured party, as well as any expenses incurred, loss of actual wages or earnings[2]. Thus as a result, an individual who is awarded damages for loss of actual and future earnings due to personal injury, is exempted from having these charged under Article 4(1)(g). Although damages are generally regarded as remedial, whose purpose is to restore an injured party to the position the party was in before being harmed, these damages correspond to a recovery of income which would have otherwise been taxable had they been earned by the injured party through employment or trade. The same rationale applies to damages awarded by a court in cases of death which ensues as a consequence of the act giving rise to damages. The court would award the heirs of the deceased, damages as in the case of permanent total incapacity.[3] To a certain extent, the provision of Article 12(h) does not in any case create any real exemption because capital sums are in any case not taxable. The provision merely clarifies that the cashing of the said items is not taxable.[4]
One has to see how damages paid in installments are treated in comparison to those given in the form of a capital sum. The charge of annual income was introduced in the Income Tax Act to cover income of a recurring nature, which did not fit the definition and requirements of an annuity in the Civil Code. The notion of an annual payment does not imply that the income is necessarily received annually, but nevertheless has the quality of being recurrent or of being capable of recurrence.[5] Such annual payment must be a pure income payment against which no expense are chargeable[6][6], thus it seems that an award of damages paid in installments fits both criteria of a specified source and of recurrence, that is required by the law to fall within the head of charge under Article 4(1)(d).
Article 4(2) imposes tax on sums realized under any insurance against a loss of profits. It provides that such receipts are to be taken into consideration in the ascertainment of any profits or income. These recoveries are brought to charge to tax due to the fact that such monies often increase profits which would otherwise have been lost.[7]
A recent form of damages is those awarded for sexual harassment, which are awarded by the Industrial Tribunal if an employer is found guilty of such harassment. These sums of money are a way of compensation to the aggrieved party. It is not clear yet whether such damages would be included under employment income for tax purposes.[8] The US Tax Court has delivered a judgment on the taxability of this form of compensation in Michael T. Prasil, et ux. V. Commissioner. The court held that these damages could not be excluded from the recipient’s gross income since they were not being paid by way of compensation for physical injury, and she had failed to prove that the harassment she suffered caused her physical harm.[9]
Article 4(a) covers tax on gains or profits from any trade, business, profession or vocation. Thus damages awarded in a judgment as a compensation for lost profits, would be chargeable as ordinary income. Article 4(b) provides for gains or profits from any employment or office, including the value of any benefit provided by reason of any employment or office. Damages awarded for unfair dismissal, where it results in the payment of lost income, would be deemed to be the receipt of taxable wages. In this scenario, the UK courts apply the Gourley principle, where an award of damages should be reduced on account of taxation. The principle is that a person must not be placed in a better or worse position as a result of a breach of contract than if the contract had actually been performed. The potential for being placed in a better position will arise in cases where a payment made from one party to another would be subject to tax in the event that the contract had been properly performed, but the damages are not themselves subject to tax. In such a case, the payment of damages must be reduced accordingly. For instance if an employer has failed to give proper notice of termination to an employee, the amount of damages is first calculated by reference to the pay and benefits that the employee would have received during the notice period if proper notice had been given. If the employee would have received his ordinary pay during his notice period, this would have been taxed. To satisfy the Gourley principle, the damages must therefore be reduced to the net income.[10]
In the UK, certain types of damages are non-taxable, for example, compensation or damages awarded for personal injury whether received in a lump sum or over a period and whether awarded by a court or agreed in an out of court settlement. Other types of damages will be taxable – for example, if an accountant successfully sues a former client for non-payment of fees. The fact that the client has been compelled to pay the fees does not change the nature of the receipt in the accountant’s hands. The principle employed is that where compensatory damages are awarded which represent a loss of profits, tax must be paid on them because the profits themselves would have been taxable.
Regarding employment termination benefits, the Income Tax act provides an exemption from tax on any capital sum received by ay of commutation of pension, retiring or death gratuity or received as consolidated compensation for death or injuries. The court held that the exemption only applies to sums of a capital nature paid by way of gratuity and proceeded to interpret the meaning of the term gratuity. A gratuity is a payment which is not made by way of compensation. It remains a gratuity for the purposes of the exemption even though such gratuity might be due at law.[11]
[1] Direct Taxation Manual Part 1 – Pg 207
[2] Article 1045(1) Chapter 16 Laws of Malta
[3] Article 1046 Chapter 16 Laws of Malta
[4] An Introduction to Income Tax Theory – Robert Attard Pg 149
[5] Direct Taxation Manual Part 1 – Pg 199
[6] Direct Taxation Manual Part 1 – Pg 200
[7] Direct Taxation Manual Part 1 – Pg 207
[8] An Introduction to Income Tax Theory – Robert Attard Pg 106
[9] An Introduction to Income Tax Theory – Robert Attard Pg 107
[10] www.hmrc.gov.uk/manuals/eimanual/eim13070.htm
[11] An Introduction to Income Tax Theory – Robert Attard Pg 105
