Recent cases clarify some of the principles litigation lawyers should be aware of when dealing with claims for damages that involve possible tax consequences for the plaintiff.
Tax can affect the calculation of damages, sometimes in complex ways. When considering claims for damages or other compensation, litigation lawyers should keep tax consequences front of mind. Questions to ask include: Should damages be calculated on a pre-tax or post-tax basis? Should damages be grossed-up to take into account the possibility that the award of damages will be taxed in the hands of the plaintiff? What happens if the tax consequences of the award of damages are not certain? Should orders be sought for the defendant to indemnify a plaintiff for a possible future tax assessment? Should the GST component of individual items be excised from the amount of damages claimed by the plaintiff?
Unfortunately, answers to these questions are not always simple and clear-cut and the authorities do not always provide clear guidance for practitioners. In the recent decision of Millington v Waste Wise Environmental (Millington),1 Croft J said that “[a] review of the authorities only muddies the already-opaque waters”.2 However, some principles can be drawn to assist practitioners when framing or defending a claim for damages.
Income tax consequences of an award of damages
There are three main ways in which damages can be subject to income tax.3 First, damages may be assessed as ordinary income under s6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) if the damages are a recoupment of what would have been ordinary income. A good example would be damages awarded for non-performance of a business contract.4
Second, damages may be assessed as statutory income, including under s15-30 of the ITAA 1997 which is concerned with amounts received by way of insurance or indemnity for a lost amount that would have been included in assessable income.
Third, damages may be assessed under the capital gains provisions in Part 3 of the ITAA 1997. The capital gains provisions are likely to pick up many awards of damages if they are not assessed as ordinary or statutory income. This is because a capital gain (or loss) may be triggered by CGT event C2, which occurs when ownership of an intangible CGT asset ends by being “released, discharged or satisfied”.5 As the definition of a CGT asset is so broad,6 CGT event C2 picks up the ending of a contractual, tortious or statutory right to the subject matter of litigation, and may therefore lead to a capital gain. Taxation Ruling 95/35, which is binding on the Commissioner of Taxation, sets out further detailed examples of how the Commissioner will assess damages under the capital gains provisions.
Damages for personal injuries normally escape taxation because compensation for lost earning capacity is not on revenue account (and therefore not assessable as ordinary or statutory income). There is also an exemption in the capital gains provisions for amounts paid for personal injuries.7
Where damages are not liable to taxation (such as for personal injuries),8 they are assessed by reference to the lost after-tax earnings of the claimant.9
Damages and tax
The compensatory principle of damages is to make good the plaintiff’s loss.10 This principle suggests that where the plaintiff’s damages are subject to tax, damages should be grossed-up to compensate the plaintiff. This approach was summarised most recently in Victoria in Davinski Nominees v Bowler Holdings, by Kaye J who said:
“. . . the function of damages is to provide fair compensation for a loss sustained by a claimant . . . [W]here the award of damages is liable to taxation, and where it is possible to calculate, with reasonable certainty, both the damages on the basis of the plaintiff’s lost post-tax earnings, and also the tax liability arising from the compensatory verdict, it would be unfair to assess damages, without taking the relevant tax implications into account. In such a case, the assessment of damages, ignoring tax, would not result in an amount of compensation, which is fair both to the claimant and to the defendant”.11
However, it is not always possible to calculate a plaintiff’s tax liability with certainty. This uncertainty may make courts wary of dealing with this issue, despite the broad applicability of the compensatory principle. For example, former NSW Supreme Court Justice Gzell, writing in the Australian Law Journal, has suggested that courts in commercial litigation should not adjust damages, whether for income tax, capital gains tax or GST. Instead, he argues, it should be left to the taxing provisions, and the courts should not attempt to shift the tax consequences from one party to another. He suggests his approach, if adopted, “will make the life of a judge a little easier”.12 While Justice Gzell’s view has not been explicitly adopted, the complexity and lack of certainty surrounding potential tax consequences may mean that tax does not get taken into account in the assessment of damages.
There are several key questions for parties: What are the tax consequences on the plaintiff from the award of damages? Can they be established to the court’s satisfaction through expert evidence and/or legal submission? As noted by Croft J in Millington, addressing this latter question may require voluminous evidence to assist the court in calculating the proper amount of compensation, which may have the result of increasing costs for all involved. Consequently, do the extra complexity and costs outweigh the marginal tax implications for the plaintiff? Finally, where there is complexity there may also be risks from a tax liability perspective in running an argument that damages are taxable. This is because the Commissioner, not being a party to the litigation, may not subsequently agree with a court’s ruling.
A recent illustration where the tax consequences were taken into account by the court in assessing damages was the Queensland decision in Westpac Banking Corporation v Jamieson.13 This case concerned a claim by husband and wife investors who had received financial advice from a Westpac employee. At trial, Westpac was found to be negligent, in breach of contract and in contravention of the Australian Securities and Investments Commission Act 2001, and was ordered to pay damages for the plaintiffs’ loss grossed-up to take into account the likely tax consequences.14
On appeal, there was no dispute the damages should be grossed-up to compensate for income tax. The Court of Appeal, however, rejected an argument that the grossed-up component of damages should be repeatedly grossed-up to account for tax on the grossed-up amount. Both experts in the appeal had assumed that the entirety of the damages (including the grossed-up amount) would be subject to tax as statutory income. The primary reason for dismissing this argument turned on the Court of Appeal’s construction of the particular taxing provision. However, the Court also took account of the fact that no evidence was led to support the assumption made by the experts that the Commissioner would have taxed the grossed-up component of the damages as statutory income.15
If this issue had occurred in a capital gains context, the outcome may have been different. This is because the Commissioner has ruled that if the court awards an additional amount of compensation to cover an additional capital gains liability, this amount will be taken into account when calculating the quantum of the capital gain.16
Damages and GST
An issue that often arises where a plaintiff seeks damages for costs already incurred is whether the plaintiff can properly claim the GST component of those costs. The resolution of this issue depends on the application of the compensatory principle and the GST registration status of the party awarded the damages.
A taxpayer registered, or required to be registered, for GST can claim an input tax credit for amounts that it pays in GST.17 As the compensatory principle is to make good the plaintiff’s loss, the court will exclude the GST component from damages where the plaintiff can recover the GST component through the taxation system.18 The question arises, however, whether it makes any difference if the plaintiff, even though entitled to, has not in fact claimed an input tax credit.
This issue arose in the 2012 decision in Fulton Hogan Constructions v Grenadier Manufacturing.19 Here, the plaintiff sought damages arising from defects in a footbridge, which it had paid to rectify. Almond J said that it was reasonable to infer that in the ordinary course, Fulton Hogan would have already been compensated for the GST it had paid for the rectification works. There was evidence, however, that Fulton Hogan had not claimed GST on a small proportion of these amounts because it was in dispute with a third party. For these amounts, Almond J ordered that an allowance for GST should be made for these repair costs in the award of damages.20
In Millington, Croft J arrived at a slightly different outcome. Waste Wise had claimed damages for the GST-inclusive repair costs of its garbage truck, which had been negligently damaged by Millington. Waste Wise was registered for GST so could have claimed an input tax credit. It conducted its case, however, on the basis that it would not claim any input tax credits and therefore was entitled to the GST-inclusive amount.
At first instance, the Magistrates’ Court took a two-staged approach – it ordered Millington to pay Waste Wise the GST-inclusive amount, but it also ordered that Waste Wise subsequently repay Millington the input tax credit it was entitled to claim. On appeal to the Supreme Court, Croft J said that to comply with the compensatory principle, Millington should simply pay Waste Wise the GST-exclusive repair costs of the truck.21
Further, Croft J said that requiring a business to claim an input tax credit was not an unreasonable imposition. Therefore the law relating to mitigation of loss required that the award of damages be reduced to the extent that Waste Wise had not acted reasonably in not claiming the input tax credits to which it was entitled.22
Following the approach taken in Millington, more recently in Dual Homes v Moores Legal, a solicitor was ordered to pay damages of GST-exclusive sums to compensate for professional costs which were incurred by a builder as a result of negligent legal advice provided to it.23
Of course, there are situations where GST may be included in the judgment sum, for example, damages where the plaintiff is not registered for GST. In these cases, the assessment of damages should include the GST on any individual items that go to make up the quantum of loss.24
Another example is where the damages themselves constitute payment for a current or earlier “taxable supply” and therefore may be subject to GST.25 In these cases, the damages may be grossed-up by 10 per cent to include the expected GST to be paid by the plaintiff on the judgment sum. This issue arose in Peet v Richmond (No 2) which involved a quantum meruit award, which Hollingworth J said by its very nature involved the payment for services.26 Generally, however, an award of damages and its payment will not constitute a “taxable supply”27 and courts will not need to gross-up damages to allow for GST.
Uncertainty and orders for indemnity
Calculating a plaintiff’s tax liability with certainty is sometimes difficult because of the complexity of their tax circumstances. The case law does not offer a simple, consistent solution where tax outcomes are uncertain.
Where there is uncertainty, the court may consider whether it is appropriate to make a declaratory order for the defendant to indemnify the plaintiff for the possible future tax consequences of the damages. Alternatively, it may consider whether to require the plaintiff to undertake to repay the defendant any overcompensation for tax. Here, uncertain tax outcomes appear to have driven courts on some occasions to treat the tax component as an exception to the “once-and-for-all” rule that usually applies in the calculation of damages.28
In Millington, Croft J said that certainty is the keystone in the decision-making process for the tax component of damages. Because the amount of the loss (including tax) was clearly quantified, an order for fixed damages could readily be made and there was no need for an amount to be paid back, or for an indemnity to be provided.29 Certainty with regard to the tax component in this case allowed Croft J to adopt his preferred approach, which “must always be to provide an order which as accurately as possible compensates the party for the loss suffered in a single, ‘once-off’ payment”.30
Croft J did say, however, that there may be situations where uncertainties about the tax outcomes are such that it is “appropriate, indeed preferable”, for the court to make declaratory orders indemnifying the plaintiff against tax consequences “in order to achieve greater accuracy in the calculation of damages”.31
This remains an issue ripe for further argument in the muddied waters where tax meets damages.
-  VSC 167; (2015) 295 FLR 301.
- Note 1 above, at .
- For a more detailed overview of the taxation consequences of damages awards see, for example: M Y Bearman, “Income Tax, CGT and GST on Judgments and Settlements” (2015) Victorian Tax Bar; C W Pincus QC and Steven White, “Taxation of Compensatory Payments and Judgments” (2001) 75 Australian Law Journal 378.
- Commissioner of Taxation (NSW) v Meeks (1915) 19 CLR 568, at 580.
- ITAA 1997, s104-25.
- ITAA 1997, s108-5(1).
- ITAA 1997, s118-37(1)(b).
- Cullen v Trappell (1980) 146 CLR 1 (Gibbs, Stephen, Mason and Wilson JJ); Wrongs Act 1958, s28A.
- Davinski Nominees v Bowler Holdings  VSC 220, at .
- Todorovic v Waller (1981) 150 CLR 402, at 412 (Gibbs CJ and Wilson J).
- Note 9 above; and Note 1 above, at .
- Justice Ian Gzell, “The Courts, Tax and Commercial Litigation” (2007) 81 Australian Law Journal 866, at 879-880.
-  QCA 50; (2015) 294 FLR 48; and first instance at Jamieson v Westpac Banking Corporation (2014) 283 FLR 286.
- Jamieson v Westpac Banking Corporation (2014) 283 FLR 286 ; applying Tomasetti v Brailey (2012) 274 FLR 248, at .
- Note 13 above, at -.
- Taxation Ruling 95/35, at .
- A New Tax System (Goods and Services Tax) Act 1999, s11-20.
- Gagner Pty Ltd v Canturi Corporation Pty Ltd (2009) 262 ALR 691, at ,  and ; Fulton Hogan Constructions v Grenadier Manufacturing  VSC 358, at .
- Note 18 above.
- Note 18 above, at .
- Note 1 above, at .
- Note 1 above, at -.
- Dual Homes Pty Ltd v Moores Legal Pty Ltd  VSC 86; (2016) 306 FLR 277, at .
- See for example cases cited in Gagner, note 18 above, at -.
- GST Ruling 2001/4, , ; See also Dual Homes, note 23 above, at .
- Peet v Richmond (No 2)  VSC 585, at .
- GST Ruling 2001/4, -; Padstow Corporation Pty Ltd v Fleming (No 3)  NSWSC 24, at -.
- Note 1 above, at - and cases cited there.
- Note 1 above, at .
- Note 1 above, at .
- Note 1 above, at .