Meaning and Types of Damages
Damages are the remedy for the loss or injury sustained by the claimant. Damages can broadly be categorized into the followings:
- Compensatory Damages
- Statutory Damages
- Nominal Damages
- Punitive Damages
- Restitutionary / Disgorgement Damages
The nature of taxation on the kind of claim/award one receives from the damages would depend on the nature of the claim itself. Damages sometimes may be in the nature of the compensation receivable from the court decision or other judicial awards or the by the reason of insurance/compensation related contracts for the particular loss or injury. The court decision or the contract from which the award originates does not typically define the term or mode on which the damages/compensation may be taxable to the recipient; it is usually governed by the tax laws itself.
As a result of the lengthy litigation or the compensation related claim process with your insurer – and once the award/compensation has been handed – there arises a few prominent question from tax perspective, that you can expect from your accountant:
- What is the amount of the award / compensation?
- Whether the amount of the award / compensation is taxable or not?
- If such damages are taxable, what is the taxable amount and at what is the rate of taxation?
Tax Practitioners, Accountants, Lawyers and Clients should all be aware to consider the tax implications of the damages sought from the outset. In some instances, the nature of the action clearly determines whether the damages will be taxable by rule of law – as some form of the damages or compensation are clearly not taxable under the purview of the tax laws. However, in other cases – which is in most of the cases, there may be the possibility of taxation where the damages are deemed income and, if so, are they capital gains or income and what rate of taxation should be applicable on such amount.
What do the Tax Laws Generally Say?
It is very strange to note that Income Tax Laws around the world generally do not have specific sections to deal with the taxation of the awards, damages or compensation. As a result, the Courts and Practitioners often turn to the basic accounting and income tax principles that are – strangely – capable of governing the tax treatment of the awards, damages and settlements. The default position of the tax law is that the damages and compensation should be taxable unless there is a specific exception for non taxation.
What does the Tax Law of Nepal Say?
The Tax Law of Nepal is modeled after The Commonwealth of Symmetrica. Thus the characterization criteria for the Compensation Payments is also same as those under the Model Law. The principle of the taxation of such damages/compensation follows the basics of payments basis income tax. The characterization under Section 31 of the Income Tax Act, 2058 of Nepal is the first supplementary rule of this type. It concerns compensation and recovery payments. Section 31 does not re-characterize compensation payments according to the amount compensated for. Rather, it treats compensation payments in the manner they would have been treated if they were so re-characterised. For example, compensation for a deductible cost or lost income will be included in calculating income. This treatment is provided for in section 31, which is similar to the other inclusive limbs of the schedular basis tax system of Nepal.
Inclusive Limbs: Section 7, 8 and 9
Section 7, 8 and 9 attempts to define the scope of the inclusion of the taxable amount under the headings of Business Income, Employment Income and Investment Income respectively. A inclusion provision under each of these sections follows that the amount characterized under Section 31 of the Chapter 7 should be subjected to inclusion under the income heads of Section 7, 8 or 9 as Assessable Income as applicable.
Provision under Section 7, 8 and 9: Income From Business, Employment or Investment
- Section 7(2)(h): Other amounts required to be included under Chapters 6 or 7 or Sections 56 or Section 60.
- Section 8(2)(i): Other amounts required to be included under Chapters 6 or 7
- Section 9(2)(g): Other amounts required to be included under Chapters 6 or 7 or section 56.
Characterization Limb: Section 31
Section 31: Where a person or an associate of a person derives a compensation amount, including a payment under insurance that compensates for the following things then, at the time the compensation amount is derived, it shall be included in calculating the income from the employment, business, or investment, as the case requires:
(a) Compensation for income from or an amount to be included in calculating the person’s income from a business, employment, or investment, which the person expects or expected to derive, or
(b) Then, at the time the compensation amount is derived, it shall be included in calculating the income from the employment, business, or investment, as the case requires.
1. Compensation payments received by resident natural persons in relation to the corporal (body) damage caused by personal accidents need not be included in the income and medical expenses relating to such accidents shall not be claimed for medical tax credit under Section 51.
2. Compensation payments received in relation to the death of a natural person.
The Helpful “Surrogatum Principle”: that ITA follows as well
As discussed earlier – it is not possible for Tax Laws to discuss each and every form of compensation to establish its taxability. So we turn to the principle known as the surrogatum principle; that is a common law principle that essentially governs the tax treatment of damages awards and settlements. The surrogatum principle aims at determining what the payment is intended to replace and, once that is determined, determine the tax treatment of the replaced amount. The principle of the taxation under Section 31 also is an example of Surrogatum Principle and the similar principle has also been laid in Section 66 of the The Commonwealth of Symmetrica Income Tax Act.
The surrogatum principle aims at determining what the payment is intended to replace and, once that is determined, determine the tax treatment of the replaced amount. Indeed, proper characterization of each component of damages/compensation claimed will reduce the uncertainty of subsequent treatment of damages for tax purposes. The difficulty for the Revenue Tribunals and Courts is in the characterization of the underlying nature of the damages.
What’s in the Income Tax Directive 2066?
Here is the explanation Income Tax Directive 2066 (With Third Amendment 2077) offers regarding the taxation of the compensation related payments:
On Types of Damages / Compensation
यस ऐन अनुसार कुनै पनि व्यक्तिले वा निजको सम्बद्ध व्यक्तिले बीमा बापतको भुक्तानी वा अन्य क्षतिपूर्ति बापत भुक्तानी प्राप्त गरेमा सो क्षतिपूर्ति बापत प्राप्त गरेको रकम प्राप्त गरेको समयमा नै आयको प्रकृति अनुसार रोजगारीको आय, व्यवसायको आय वा लगानीको आयमा समावेश गर्नु पर्दछ । यस दफाको व्यवस्था अनुसार खर्च वा नोक्सानी भएका वर्ष सो खर्च वा नोक्सानीको सम्बन्धित दफामा उल्लेख भए बमोजिम खर्च कट्टा हुने हुनाले त्यस खर्च वा नोक्सानी बापत प्राप्त रकम भने प्राप्त हुने अधिकार सिर्जना भएको वर्षमा कुल रकम नै आयमा समावेश गर्नु पर्दछ । बीमा वा अन्य क्षतिपूर्तिका आधारमा करदाताले कम्तीमा पनि निम्न प्रकारका क्षतिपूर्ति प्राप्त गर्न सक्तछ :
मुनाफाको नोक्सानी बापतको क्षतिपुर्ति (Loss of Profit)
आम्दानीको नोक्सान भए बापतको क्षतिपूर्ति (Loss of income)
खर्च कट्टीसँगसम्बन्धित क्षतिपूर्ति
कट्टी हुने खर्चको क्षतिपूर्ति (Loss of deductible expenses)
सम्पत्ति बापतको क्षतिपूर्ति (Loss of assets – Trading stock, Depreciable assets or Business assets or non-business chargeable assets)
सम्पत्तिको क्षति बापत क्षतिपूर्ति प्राप्त हुने अवस्थामा भने करदाताले दफा ४६ को सुविधा लिन चाहेमा सो क्षतिपूर्तिलाई आयमा समावेश गर्नु पर्दैन तर दफा ४६ को प्रावधान भने पूरा गर्नुपर्दछ ।
व्यवसायको क्रममा कुनै सम्पत्तिको नोक्सान भएको अवस्थामा क्षतिपूर्ति बापतको बीमा रकम प्राप्त गर्नुपूर्व नै आफ्नो हिसावबाट अपलेखन गर्नुपर्ने तथा बीमा बापतको रकम प्राप्त भैसकेपछि करदाताले आफ्नो आयमा समावेश गर्नुपर्ने हुन्छ, अर्थात व्यापार मौज्दात (Trading Stock) मा भएको नोक्सानी बीमा रकम प्राप्त हुनु भन्दा पहिले अर्थात नोक्सानी भएकै अवस्थामा खर्च लेख्नु पर्दछ ।
On Nature of Damages / Compensation: Revenue or Capital
उदाहरण ७६.१: मानौं, कुमार कम्पनी प्रा. लि. ले कपडाको व्यवसाय गर्ने गरेको रहेछ । उक्त कम्पनीको गोदाममा मिति २०६५।३।२० मा आगो लागेको कारणले गर्दा Stock मा रहेको रु.५ लाख मूल्य बराबरको कपडा जलेर नष्ट भएको रहेछ । कम्पनीले उक्त गोदामको बीमा गरेको बीमा कम्पनी समक्ष मिति २०६५।३।२२ मा बीमा दाबी गरेको रहेछ । तर दाबी गरेको रकम मिति २०६५।१०।२० मा मात्रै प्राप्त गर्यो भने यस अवस्थामा व्यापार मौज्दात (Trading Stock) बापत भएको नोक्सानीलाई आर्थिक वर्ष २०६४/६५ मा ऐनको दफा १५ अनुसार खर्च दावी गर्नु पर्दछ र बीमा दाबी बापत प्राप्त गरेको रकम भने आ.व. २०६५/६६ मा मात्रै प्राप्त गरेको (वा प्राप्त गर्ने अधिकार सिर्जना भएको) हुँदा सोही प्राप्त गरेको आ.व. अर्थात आ.व. २०६५/६६ मा ऐनको दफा ३१ बमोजिम आयमा समावेश गर्नु पर्दछ ।
उदाहरण ७६.२: मानौ, माथि उदाहरण ७६.१ मा उल्लेख गरिएको कुमार कम्पनी प्रा. लि. मा आगो लाग्दा उक्त कम्पनीमा भएका फर्निचर तथा कार्यालय उपकरण पनि जलेर नष्ट भएका रहेछन् । निज कम्पनीले उक्त फर्निचर र कार्यालय उपकरणको नोक्सानी बापत बीमा कम्पनीसँग मिति २०६५।३।२२ मा बीमा दाबी गरेको र बीमा दाबी बापत मिति २०६५।१०।२० मा रकम प्राप्त गरेको रहेछ सो वर्षको अन्तमा सो समूहको सम्पत्तिको हास आधार रु.५,००,०००/- रहेछ र कम्पनीले बीमा कम्पनीसँग भएको Insurance Policy अनुसार रु.६,००,०००/- बीमा दावी गरेको रहेछ र बीमा दाबी गरेको रकममध्ये रु.५,००,०००/- मात्रै मिति २०६५।१०।२० मा प्राप्त गरेको रहेछ भने आ.व. २०६४/६५ मा कर प्रयोजनको लागि निम्नानुसार तरिकाले लेखाङ्कन गर्नु पर्दछ ।
आ.व. २०६४/६५ मा
फर्निचर र कार्यालय सामानको (समुह “ख”) को ह्रास आधार: रु.५,००,०००
ह्रास खर्च (२५ प्रतिशतले): रु.१,२५,०००
अर्को वर्षलाई सर्ने हास आधार: रु.३,७५,०००
आ.व. २०६५/६६ मा
सुरुको ह्रास आधार: रु.३,७५,०००
बीमा दाबी रकम प्राप्त: रु.५,००,०००
ह्रासयोग्य सम्पत्तिको निःसर्गबाट प्राप्त लाभ (आयमा समावेश हुने) रु.१,२५,०००
उदाहरण ७६.३: मानों, माथि उदाहरण ७६.१ मा उल्लेख गरिएको कुमार कम्पनी प्रा.लि.मा आगो लाग्दा उक्त कम्पनीमा भएका फर्निचर तथा कार्यालय उपकरणमध्ये रु. ४,५०,०००/ किताबी मूल्यको फर्निचर तथा कार्यालय उपकरण जलेर नष्ट भएका रहेछन्। सो कम्पनीले उक्त फर्निचर र कार्यालय उपकरणको नोक्सानी बापत बीमा कम्पनीसँग मिति २०६५।३।२२ मा बीमा दावी गरेको र बीमा दाबी बापत मिति २०६५१०२० मा रकम प्राप्त गरेको रहेछ । सो वर्षको अन्तमा सो समुहको सम्पत्तिको कुल हास आधार रु.५,००,०००/- रहेछ र कम्पनीले बीमा कम्पनीसँग रु.६,००,०००/- बीमा दाबी गरेको रहेछ । बीमा दाबी गरेको रकममध्ये रु.३,५०,०००/- मात्रै मिति २०६५१०२०मा प्राप्त गरेको रहेछ भने आ.व. २०६४/६५ र आ.व. २०६५/६६ मा कर प्रयोजनको लागि निम्न तरिकाले लेखाइन गर्नु पर्दछ:
आ.व. २०६४/६५ मा
फर्निचर र कार्यालय सामानको (समुह “ख”) को ह्रास आधार: रु.५,००,०००
ह्रास खर्च २५ प्रतिशतले (समूह पुरै निःसर्ग नभएकाले ): रु.१,२५,०००
अर्को वर्षलाई सर्ने हास आधार: रु.३,७५,०००
आ.व. २०६५/६६ मा
सुरुको ह्रास आधार: रु. ३,७५,०००
न्यून, बीमा दाबी प्राप्ति: रु.३,५०,०००
वर्षको अन्तमा रहेको ह्रास आधार: रु.२५,०००
On compensation against Corporal Loss
लगानी बीमा वा जीवन बीमा वा ५ वर्षभन्दा बढी जोखिम दायित्व व्यहोर्ने बीमा गरेको र त्यस्तो बीमाबाट प्राप्त गर्ने भुक्तानीमा आफूले प्रिमियम बापत तिरेको रकम कट्टा गरी हुन आउने रकमलाई लाभ भनिन्छ । यसरी गणना गरिएको लाभ रकम भुक्तानी गर्दाका अवस्थामा ५ प्रतिशतका दरले अग्रिम कर कट्टा गरी भुक्तानी दिनु पर्दछ । सो व्यवस्थाका सम्बन्धमा तलको उदाहरणबाट स्पष्ट गरिएको छः
उदाहरण १६.२.३७: मानौं, पूर्णताले आफ्नो जीवन बीमा नेपाल जीवन बीमा संस्थानमा गराएकी रहिछन् । निजको Policy Amount (Sum Insured) रु.८,००,०००/- को प्रिमियम वापत वार्षिक रु.४०,०००/- तिर्ने गरेकी रहिछिन् । उक्त पोलिसी अवधि समाप्त हुँदासम्म निजले प्रिमियम बापत रु.६,००,०००/- भुक्तान गरी सकेकी रहिछिन् । नेपाल जीवन बीमा संस्थानबाट उक्त Policy Mature भएपछि निजले रु.१२,००,०००/- पाउने देखियो । यस्तो रकम भुक्तानी दिँदा संस्थानले लाभ गणना गर्दा रु.६,००,०००/- (१२,००,००० – ६,००,०००) मा ५ प्रतिशतका दरले हुने रु.३०,०००/- अग्रिम कर कट्टा गरी बाँकी हुन आउने रु११,७०,०००/ भुक्तानी दिनु पर्दछ । यसरी अग्रिम कर कट्टी गरी प्राप्त गरिएको भुक्तानी रकम रु.११ लाख ७० हजारलाई पूर्णताले आफ्नो अन्य आयमा समावेश भने गर्नु पर्दैन ।
उदाहरण १६.२.३८: उदाहरण १६.२.३८: मानौं, सजग सापकोटाले Accidental Insurance पोलिसी नेपाल जीवन बीमा संस्थानबाट खरिद गरेका रहेछन् र नियमित रूपमा प्रिमियम भुक्तानी गरिआएका रहेछन् । पोलिसी खरिद गरेको तेस्रो वर्ष निजको दुर्घटना भई हात भाँचिएछ। उक्त बीमा कम्पनीले क्षतीपूर्ति बापत रु.५०,०००/- निजलाई भुक्तानी दिएको रहेछ यसरी बीमा भुक्तानी प्राप्त गरेको समयसम्म निजले रु. २०,०००/- सो पोलिसी बापत प्रिमियम दाखिला गरेका रहेछन् । यस्तो क्षतिपूर्ति बापत प्राप्त रकम दफा ३१ बमोजिम कर नलाग्ने हुँदा भुक्तानीमा दफा ८८ बमोजिम अग्रिम कर कट्टी गर्नु पर्दैन ।
Retrenchment and VRS Related Compensation
रोजगारीको नोक्सानी रोजगारीको नोक्सानी अवकाश हने प्रक्रियामध्ये एक हो। तर यो अन्य प्रक्रिया भन्दा भिन्न प्रकारले रोजगारीबाट रोजगारकतां विमुख हुन्छन् । उदाहरणको लागि Liquidation, संस्थाको वर्तमान कर्मचारी नराख्ने शर्तसहितको निजीकरण, संस्थामा कार्यरत कर्मचारी/कामदार अशक्त भई काम गर्न नसक्ने अवस्था भई रोजगारीबाट छोड्नुपर्ने अवस्था, कर्मचारी कटौतीमा परेका रोजगारकर्ता आदि माथि उल्लेख गरिएका अवस्थामा कामदार कर्मचारीको रोजगारीको नोक्सानी हुने र यसरी रोजगारीको नोक्सानी भए बापत सम्बन्धित संस्थाबाट क्षतिपूर्ति (Compensation) बापत प्राप्त गरिने रकमलाई ऐनको दफा ८ को उपदफा (२) को खण्ड (ङ) अनुसार रोजगारीको आयमा समावेश गर्नु पर्दछ तर ऐनको दफा ८८ को उपदफा (१) अनुसार १५ प्रतिशतका दरले भुक्तानीमा कर कट्टा गर्नुपर्ने र ऐनको दफा ९२ को उपदफा (१) को खण्ड (छ) अनुसार अन्तिम कर कट्टी हुने हुँदा दफा ८ को उपदफा (३) अनुसार रोजगारीको आय गणना गर्दा आयमा समावेश गर्नु पर्दैन उक्त अवस्था खुल्ने उदाहरण तल दिइएको छ ।
उदाहरणको १७.३.६: मानौं, कृषि सामग्री संस्थान निजीकरण गर्ने क्रममा कर्मचारीलाई निवृत्त गर्ने तर रोजगारीको नोक्सानी भए बापत निजले पाउने सुविधाको अलावा सेवा गरेको प्रति वर्षको २ महिनाको दरले थप तलब क्षतिपूर्ति (Compensation) को रूपमा दिने निर्णय गरेको रहेछ । यस सन्दर्भमा दिपक भन्ने व्यक्तिले निम्नानुसारको भुक्तानी प्राप्त गरेका रहेछन्:
साविक तलब तथा सुविधा: रु.८०,०००/
ऐन लागू पश्चात पाकेको बिदा बापतको रकम: रु.५०,०००/
ऐन लागू पश्चात पाकेका उपदान: रु.२,५०,०००/
क्षतिपूर्ति वापत प्राप्त थप तलब: रु.४,००,०००/
उक्त भुक्तानीमध्ये ऐन लागू भएपछि पाकेको विदा वापतको रकम रु.५०,०००/-, उपदान बापतको रकम रु.२,५०,०००/- र थप तलबरु ४,००,०००/- मा ऐनको दफा ८८ को उपदफा (१) बमोजिम १५ प्रतिशतका दरले कर कट्टा गर्नुपर्छ र ऐनको दफा ९२ को उपदफा (१) को खण्ड (छ) अनुसार अन्तिम कर कट्टी हुने हुँदा दफा ८ को उपदफा (३) अनुसार रोजगारीको आय गणना गर्दा आयमा समावेश गरी आय निर्धारण गर्नु पर्दैन । तर साविक तलब तथा सुविधारु. ८०,०००/- भने रोजगारीको आयमा समावेश गर्नु पर्दछ ।
कुनै एक कारखानामा कार्यरत मजदुर कामको सिलसिलामा मेसिन चलाउँदा दुर्घटना हुनगई दाहिने हात गुमाउनु पर्यो । यसरी अपाङ्ग भइसकेपछि निजबाट कार्य गराउन सम्भव नहुने देखेपछि उक्त कारखानाले निजलाई नियमानुसार थप सुविधा दिई रोजगारीबाट अवकाश दियो । यसरी रोजगारी गुमाए (Job Loss) वापत प्राप्त गरिने क्षतिपूर्ति रकम (Retrenchment Amount) लाई आयकर प्रयोजनको लागि आयमा समावेश गर्नु पर्दछ । तर दफा ९२(१) ले यस्तो अवकाश भुक्तानी अन्तिम विधिले कर कट्टा हुने व्यवस्था गरेको हुँदा यस्तो भुक्तानीमा दफा ८८(१) बमोजिम १५ प्रतिशतका दरले कर कट्टा गरेपछि सो कर ने अन्तिम हुन्छ ।
अनिवार्य अवकाश (Compulsory Retirement): कुनै निकायले आफ्नो संस्थामा रहेका कामदार/कर्मचारी कटौती गर्ने क्रममा तोकिएको समूहलाई रोजगारीबाट अवकाश दिने वा Staff Regulation अनुसार तोकिएको अवधि उमेर पूरागरी रोजगारीबाट अवकाश हुने प्रक्रियालाई अनिवार्य अवकाश भनिन्छ । यसरी अनिवार्य अवकाश दिँदा Staff Regulation अनुसार तोकिएको अवधि उमेर पूरागरी रोजगारीबाट अवकाश हुने अवस्थाबाहेक अन्य अवस्थाबाट कामदार कर्मचारीलाई अनिवार्य अवकाश बिंदा विशेष सुविधाको पनि व्यवस्था गरिएको हुन सक्दछ । यसरी प्राप्त गरिएको विशेष सुविधाबापत प्राप्त गरिएको भुक्तानी अवकाश भुक्तानी भएको हुँदा ऐनको दफा ८८ को उपदफा (१) बमोजिम स्रोतमा १५ प्रतिशतका दरले भुक्तानीमा कर कट्टा गर्नुपर्ने र ऐनको दफा ९२ को उपदफा (१) को खण्ड (छ) अनुसार अन्तिम कर कट्टी हुने हुँदा दफा ८ को उपदफा (३) अनुसार रोजगारीको आय गणना गर्दा आयमा समावेश गर्नु पर्दैन ।
Taxable and Non Taxable Receipts
Not all forms of the award for damages or compensation are taxable. Sometimes not all parts of the taxable awards are taxable. This depends on the nature of the receipt and the losses that it is trying to surrogate – as discussed earlier. This will also depend on whether the tax laws of the land has or has not specifically excluded it from the purview of the taxation. Some forms of damages may be outright non-taxable as it never can fall under the purview of the taxation.
Once the award or compensation is certain to be received – tax practitioners will have to look closely at certain aspects from a tax perspective.
- Does the award / damages / compensation fall under the list of exempted receipts under Section 10 of the Income Tax Act? If yes, they are not taxable.
Example: Person A was bequeathed a property by person B. The heirs of person B claimed that person B had no right to transfer such property. Later the court went to decide in the favor of Person A. This bequeathed property is not taxable to A as it is already an exempted receipt under Section 10 of the Act.
- Does the award / damages / compensation received in the form of the asset fall under none of the chargeable assets under Income Tax Act? If yes, they are not taxable.
Example: A dispute of property between two brothers regarding inherited property was settled in the favor of the eldest brother. The amount is still not taxable as it still is the transfer of the property within the three generations of the family.
- What is the nature of the damages / compensation and what type of revenue or capital item it intends to surrogate?
Example: A famous defamation case of Amber Heard and Johnny Depp awarded Johnny Depp with two types of compensation. One was a certain amount for him not being able to carry his acting profession for a certain period because of the libelous article published by Heard. The other was an exemplary / punitive damages offered to Johnny Depp against the emotional loss sustained by him due to the defamation. The damages against the profession is compensation in the form of business/professional income thus it is taxable. However, the exemplary damages is the compensation for his emotional losses; personal in nature – and not covered by any income heading of the Income Tax Laws so it should not be under the purview of the taxation. But it is not this straightforward, see further discussion regarding the taxability of punitive damages in “some important questions” sections below.
Here it might be useful to define in short what is the meaning and definition of the several types of damages that we listed above:
Compensatory damages are paid to compensate the claimant for loss, injury, or harm suffered by the claimant as a result of another’s breach of duty that caused the loss. For example, compensatory damages may be awarded as the result of a negligence claim under tort law. Compensatory damages are used in contract law to put an injured party in the position it would have occupied but for the breach. Compensatory damages can be classified as special damages and general damages.
Special damages compensate the claimant for the quantifiable monetary losses he has suffered. For example, extra costs, repair or replacement of damaged property, lost earnings (both historically and in the future), loss of irreplaceable items, additional domestic costs, and so on. They are seen in both personal and commercial actions.
General damages are monetary compensation for the non-monetary aspects of the specific harm suffered. These damages are sometimes termed ‘pain, suffering and loss of amenity’. Examples of this include physical or emotional pain and suffering, loss of companionship, loss of consortium, disfigurement, loss of reputation, impairment of mental or physical capacity, hedonic damages or loss of enjoyment of life, etc. This is not easily quantifiable, and depends on the individual circumstances of the claimant.
Statutory damages are an amount stipulated within the statute rather than calculated based on the degree of harm to the plaintiff. Lawmakers will provide for statutory damages for acts in which it is difficult to determine the value of the harm to the victim. Mere violation of the law can entitle the victim to a statutory award, even if no actual injury occurred. These are different from nominal damages, in which no written sum is specified.
Nominal damages are very small damages awarded to show that the loss or harm suffered was technical rather than actual. Many times a party that has been wronged but is not able to prove significant damages will sue for nominal damages. This is particularly common in cases involving alleged violations of constitutional rights, such as freedom of speech.
Punitive damages, which are also termed exemplary damages, are not awarded in order to compensate the plaintiff, but in order to reform or deter the defendant and similar persons from pursuing a course of action such as that which damaged the plaintiff. Punitive damages are awarded only in special cases where conduct was egregiously insidious and are over and above the amount of compensatory damages, such as in the event of malice or intent. Great judicial restraint is expected to be exercised in their application.
Revenue and Capital Receipts
The general principle is that damages in lieu of receipts that would have been taxable as income remain taxable. However, determining the characterization of damages awarded on business matters and the resulting tax treatment can be difficult because determining whether those damages are deemed income or non-taxable receipts and the timing of their taxation depends on the nature of damages at issue.
If the damages awarded are for loss of income, then the general principle is that they will be considered business income and therefore taxable as business income. However, if the damages awarded relate to the loss of an income-producing asset, it will be considered to be a capital receipt and treated as realization from the capital asset. As one can imagine, the difference between loss of income and the loss of an income producing asset can be nuanced and there exists no bright-line test to differentiate the two; it is always a question of fact. We can see the explanation in the Income Tax Directive 2066 above for this.
Some Important Questions
Can General Damages be characterized as Windfall Gain?
A risk we could fall into is that whether the general damages or compensation that are received outside the purview of the business, employment and investment could rather fall into the definition of windfall gain and be taxed. In my view, this should not be the case. The term windfall gain is not a fallback space to include anything that could not be taxed elsewise.
Let’s dive into the definition of “Income” and “Windfall Gain” to elaborate this.
Section 2(h): “Income” means an income earned by any person from employment, profession, investment or windfall gain and the term also includes the total amount of that income calculated in accordance with this Act.
Section 2(hl): “Windfall gain” means a gain obtained by means of lottery, gift, prize, tips, share of earning in a game or any other gain acquired incidentally.
The term damages/compensation is none of these: Lottery (चिट्ठा), Prize (पुरस्कार), Tips (बक्सिस), Game Earnings (जितौरी). These are simply given out of the will and there is no sense of competition or compensation in them; thus they are windfall gains. However, award of damages are by definition a compensation for some form of tangible / intangible loss or injuries; they are not incidental but are causal: they express or indicate a cause.
Can Punitive Damages be characterized as Windfall Gain?
In the case of Punitive Damages the story takes a twist. It cannot be said that punitive damages are non-incidental because it can be argued that they are.
Punitive / exemplary damages are not awarded in order to compensate the plaintiff, but in order to reform or deter the defendant and similar persons from pursuing a course of action such as that which damaged the plaintiff because the actions of the defendant were egregiously insidious. So, punitive damages are not per se a compensation for damages; they are only a compensation for constructive damages as it is intended to penalize the defendant rather than compensate the plaintiff. So punitive damages and related interest could likely be taxable in the form of windfall gain. But this still is arguable in a sense that the meaning of Windfall Gain provided in the Income Tax Law still doesn’t seem to encompass the punitive damages under it.
Fate of Tax Deductibility of the Defendant
We’ve focused on plaintiffs or the claimants, since they generally are much more worried about tax effects on the compensation / damages rather than the defendants. Nevertheless, we should consider the defense / tortfeasor’s perspective too. A defendant paying a settlement or judgment will always want to deduct it. If the defendant is engaged in a trade or business, that will rarely be questioned, since litigation is a cost of doing business. But if the suit is related to investments, it may be deductible only against investment income or subject to limits under the Income Tax Laws of Nepal. If the suit is purely personal, the defendant may get no deduction at all, and that can extend to legal fees too. Defendants can also run up against questions about whether an amount can be immediately deducted or must be capitalized depending upon the revenue or capital nature of the compensation.
For example, if the buyer and seller of real estate are embroiled in a dispute, any resulting settlement payment may need to be treated as part of the purchase price and capitalized, not deducted. The tax laws governing capitalization and depreciation vary, but real estate usually must be capitalized and depreciated at the rate of 5% per annum – a far cry from an immediate deduction. The bottom line is that, sometimes that can be tempting to settle your dispute right away considering the deductibility.
Indirect Taxes in Damages / Compensation
Generally damages / compensation received are not an intended business transaction. Besides damages / compensation are provided against the actual loss suffered – which obviously doesn’t include indirect taxes. So they should generally not be subjected to any indirect taxes.
However, in the case of liquidated damages there may be an additional argument. Liquidated damages, also referred to as liquidated and ascertained damages, are damages whose amount the parties designate during the formation of a contract for the injured party to collect as compensation upon a specific breach. But still, liquidated damages cannot be said to be a consideration received for tolerating the breach or non-performance of contract. They are rather payments for not tolerating the breach of contract. Such payments indicate the compensation for loss against a breach, albeit agreed in advance, but they still do not constitute consideration for a supply and should not be taxable for indirect tax purposes.
As an example, in India the Central Board of Indirect Taxes and Customs (CBIC) has issued a circular clarifying the non applicability of GST on liquidated damages, compensation and penalty arising out of breach of contract or other provisions of law. It explains that the compensation is not by way of consideration for any other independent activity; it is just an event in the course of performance of that contract. Link to the Circular
Some Decisions by Courts on Surrogatum Principle
The Surrogatum Principle pertains to a Canadian Income Tax principle involving a person who suffers harm caused by another and may seek compensation for (a) loss of income, (b) expenses incurred, (c) property destroyed, or (d) personal injury, as well as punitive damages, under the surrogatum principle, the tax consequences of a damage or settlement payment depend on the tax treatment of the item for which the payment is intended to substitute. The Income Tax Act or Directive of Nepal doesn’t have any literature on the surrogatum principle but some seminal landmark cases from Canada can be taken as reference for this.
Compensation as Business Income
In the case of London and Thames Haven Oil Wharves,  2 All E.R. 124, the taxpayer’s jetty, which was used in its income-earning operations, was damaged by an oil tanker. In settlement of a tort claim for negligence, the taxpayer received compensation from the owner of the oil tanker, part of which compensated for the loss of the jetty during the period of repair. In holding that the compensation effectively replaced the taxpayer’s profits and was therefore taxable as income.
Business Income maybe Revenue Receipt or Capital Receipt
In Commissioners of Inland Revenue v. Fleming & Co. (Machinery), Ltd., (1951), 33 TC 57, the taxpayer received an amount as compensation for the loss of a sales agency agreement with a manufacturer of explosives. The taxpayer had been the sole selling agent pursuant to the agreement. The amount paid to the taxpayer was arrived at by doubling the normal annual commission that it had received pursuant to the agreement. The agency provided between 30% and 45% of the company’s total earnings in commissions. In finding that the amount received by the taxpayer was income, Lord Russell formulated the following test, which has been cited in several subsequent Canadian cases: “When the rights and advantages surrendered on cancellation are such as to destroy or materially to cripple the whole structure of the recipient’s profit-making apparatus, involving the serious dislocation of the normal commercial organization and resulting perhaps in the cutting down of the staff previously required, the recipient of the compensation may properly affirm that the compensation represents the price paid for the loss or sterilization of a capital asset and is therefore a capital and not a revenue receipt … On the other hand when the benefit surrendered on cancellation does not represent the loss of an enduring asset in circumstances such as those above mentioned — where for an example the structure of the recipient’s business is so fashioned as to absorb the shock as one of the normal incidents to be looked for and where it appears that the compensation received is no more than a surrogatum for the future profits surrendered — the compensation received is in use to be treated as a revenue receipt and not a capital receipt.”
In Van den Berghs, Ltd. v. Clark,  A.C. 431, the taxpayer was an English company that entered into an agreement with a competing Dutch company which provided that the two companies (which were manufacturers and dealers in margarine) would conduct their businesses in cooperation with one another along certain prescribed lines and that they would share profits or losses. The agreement was to run for thirty years, but differences subsequently arose over the proper distribution of the profits. A settlement was reached under which a lump-sum amount was paid by the Dutch company to the taxpayer and the agreement was terminated. The House of Lords held that the rights of the taxpayer under the agreement constituted a capital asset and the sum paid for their cancellation was a capital receipt.
The case of Parsons-Steiner Ltd. v. Minister of National Revenue, 62 DTC 1148 (Ex. Ct.) was one of the first in Canada to consider the nature of damages received upon the termination of a business contract. The taxpayer received a lump-sum payment upon the cancellation of a sales agency contract under which it sold “Doulton” figurines and china products. This agency, when combined with another with the same company, accounted for 80% of the taxpayer’s business and in the last two or three years of the agency one of the products accounted for 55% of the taxpayer’s business. The agency relationship had lasted twenty years prior to its termination. Given the length of the agency relationship, its importance to the taxpayer’s business operations, and the fact that the taxpayer suffered decreased sales by reason of its inability to replace the agency with an equivalent arrangement, the Exchequer Court found the damages to be capital. The Court held that the damages related to the loss of the taxpayer’s interest in the goodwill and business in Doulton products in Canada, which the Court viewed as “a capital asset of an enduring nature”.
In H. A. Roberts Ltd. v. Minister of National Revenue, 69 DTC 5249, the taxpayer carried on a mortgage business in one of its five departments, having obtained two mortgage agencies (as well as a third less significant agency). The mortgage department was operated as a separate division from the taxpayer’s other businesses. The net income of the mortgage department ranged from 27% to 51% of the taxpayer’s total net income. The two agencies were canceled and pursuant to the agency agreements the taxpayer received compensation payments. The cancellation of the agencies terminated the taxpayer’s mortgage business; the department was closed and the staff was disbanded. In holding that the payments were capital, the Supreme Court of Canada held that the loss of the two agencies represented “the loss of capital assets of an enduring nature the value of which had been built up over the years and that therefore the payments received by this appellant represented capital receipts”.
In Pe Ben Industries Company Limited v. The Queen, (88 DTC 6347), heard concurrently with Canadian National Railway, a similar payment was held to be capital. In that case, Justice Strayer concluded that the payment was compensation for the destruction of a distinct part of the taxpayer’s business. It had been the first “intermodal” undertaking of the taxpayer, which required it to establish a base of operations at a rail yard solely for that purpose. Justice Strayer held that the termination of the contract put an end to the intermodal operations of the taxpayer, such that the payment was capital. He went on to hold that the taxpayer’s rights under the contract constituted “property” and that the termination payment constituted “compensation for property destroyed” and therefore proceeds of disposition received in respect of the property. Since the taxpayer had a nil adjusted cost basis in the contract, the amount of the termination payment was a capital gain.
In T. Eaton Company Limited v. The Queen, 99 DTC 5178, the taxpayer was a tenant under a long-term lease for retail space in a shopping centre. The terms of the lease included a “participation clause” entitling the taxpayer to 20% of the annual net profits of the shopping centre over the duration of the lease. For several years, the taxpayer reported the amounts received under the participation clause as income. In 1989, the landlord offered to buy out the participation clause for $9.25 million. The offer was accepted and the taxpayer reported the $9.25 million amount as proceeds of the disposition of a capital property that had an acquisition cost of nil. Accordingly, the taxpayer reported a capital gain of $9.25 million. The Minister reassessed the taxpayer on the ground that the entire amount constituted income from a business. The Tax Court of Canada agreed with the Minister and characterized the participation clause as part of an ordinary business contract not forming part of the taxpayer’s capital structure. However, the Tax Court decision was overturned on appeal to the Federal Court of Appeal. The Federal Court rejected the Minister’s position that the participation clause was analogous to an ordinary trade contract. The Federal Court instead characterized the participation clause as an integral part of the lease, which was a capital asset of the taxpayer. The Court held that buy-out of the participation clause had the effect of diminishing the value of this capital asset by $9.25 million. Accordingly, the buy-out amount was on capital account.
In The Queen v. Manley, 85 DTC 5150, the taxpayer was hired to find a purchaser for the shares of a family-owned company in exchange for a finder’s fee. When he found such a purchaser but was not paid, he sued the former controlling shareholder of the company, who on behalf of the other family shareholders had agreed to pay the finder’s fee. The taxpayer was successful in the lawsuit and was awarded damages for the shareholder’s breach of warranty of authority. In holding that the damages were income from a business, the Federal Court of Appeal held that they were compensation for the failure to receive the finder’s fee, which would have been income from a business because the taxpayer had engaged in an adventure in the nature of trade.
In Canadian National Railway Company v. The Queen, 88 DTC 6340, the taxpayer received an amount upon the termination of a contract for the transportation by road and rail of certain supplies and building materials. Justice Strayer of the Federal Court–Trial Division held that the operations under the contract did not constitute a separate business and that they were not that significant that the termination of the contract destroyed the taxpayer’s “profit-making apparatus” or seriously dislocated its “normal commercial organization”. He went on to hold that the purpose of the compensation provision in the contract was to enable the taxpayer to “absorb the shock as one of the normal incidents to be looked for” and that the compensation received was “no more than a surrogatum for the future profits surrendered”. As a result, the payment was revenue income.
Part Taxable and Part Non Taxable
In the case of Tsiaprailis v. The Queen, 2005 DTC 5119, the Supreme Court of Canada applied the principle in its consideration of a more specific statutory provision dealing with amounts received pursuant to a disability insurance plan, namely paragraph 6(1)(f). The case dealt with a lump-sum settlement payment received in respect of a disputed claim under a disability insurance plan. The payment ostensibly represented both past disability benefits accruing to the time of the settlement and the taxpayer’s foregone future benefits under the plan. The Court held that the portion of the lump-sum payment reflecting the taxpayer’s future benefits was not made pursuant to the insurance plan because there was no obligation to make such a lump-sum payment under the terms of the plan. Therefore, such amount was not taxable under paragraph 6(1)(f). However, turning to the portion of the payment that represented the past benefits under the plan, the Court applied the surrogatum principle in concluding that the portion was taxable under paragraph 6(1)(f) because it was meant to replace amounts that were payable pursuant to the plan.
On Compensation Received by Non Resident Person
In Transocean Offshore Limited v. The Queen, 2005 DTC 5201, the non-resident taxpayer received a US$40 million lump-sum payment from a group of Canadian residents who had repudiated a bare boat charter agreement. The Federal Court of Appeal held that withholding tax under paragraph 212(1)(d) applied to the payment because it was made “in lieu of” rent that would have been pursuant to the agreement had it not been repudiated. Although the Court did not apply the judge-made surrogatum principle, simply because the “in lieu of” language of paragraph 212(1)(d) effectively constituted a statutory surrogatum rule, Justice Sharlow described the surrogatum principle as follows: “… a judge-made rule, sometimes called the “surrogatum principle”, by which the tax treatment of a payment of damages or a settlement payment is considered to be the same as the tax treatment of whatever the payment is intended to replace. Thus, an amount paid as a settlement or as damages is income if it is paid as compensation for lost future rent … It is a capital receipt if it is compensation for a diminution of capital of the recipient: Westfair Foods Ltd v. Minister of National Revenue,  1 C.T.C. 146, 91 DTC 5073 (F.C.T.D.), affirmed  2 C.T.C. 343, 91 DTC 5625 (F.C.A.).”
“The surrogatum principle need not be considered in this case because the words “in lieu of” in paragraph 212(1)(d) of the Income Tax Act express a similar idea. The fact finding process that precedes the application of the surrogatum principle is similar to the fact finding process that must be undertaken to determine whether a payment has been made “in lieu of” a specified thing. Here, the fact finding exercise was completed when the Judge determined that the US$40 million payment was made as compensation for lost future rent.
Recouping Business Sustained in the Past
Recently, the surrogatum principle was applied by the Tax Court of Canada in Bourgault Industries Ltd. v. The Queen, 2006 DTC 3420, where a settlement payment arising from an infringement of the taxpayer’s patents was held to be on account of lost profits and therefore included in the taxpayer’s income. The principle was also applied by the Tax Court in Bueti et al. v. The Queen, 2006 DTC 3047, where the taxpayer as landlord received a lump-sum payment upon the termination of a lease by the tenant. The payment was held to reflect foregone rent under the lease and therefore was included in the taxpayer’s income. Both the Bourgault and Bueti decisions were appealed to the Federal Court of Appeal. Those appeals had not been decided at the time of writing.”