WHEN a party to a contract fails to perform in accordance with the stated terms and conditions, legal action can be taken by the other party to seek restitution for any damages or losses suffered due to a breach of contract.
Under contract law and common law, there are various types of damages that could be awarded by the courts – general damages, which refer to losses that arise naturally in the usual course of things from the breach; special damages which are losses arising from special circumstances known to both parties at the time of contract; liquidated damages, which are a pre-agreed sum stated in the contract which is payable upon the breach of contract; and damages to potential loss of profit or wasted expenses incurred due to the breach.
Although there are many other types of damages, these are the most commonly awarded damages for contractual infractions.
Are such sums taxable?
When it comes to assessing the taxability of courts award damages, the common misconception is that such sums are not income and should not be brought to tax as they are not earned in the normal course of business. However, this is not usually the case.
The tax treatment depends on the nature and purpose of the damages awarded, and will be reliant on the underlying nature of the transaction that gave rise to the court awarded damages.
One test is to determine whether the damages award is a form of compensation for loss of income or profits, or for loss or destruction of assets. If the damages are awarded due to unpaid salaries, or potential loss of business profits, then such damages are generally taxable revenues. However, damages to compensate any damages to property or assets, or resulting in loss of goodwill could possibly be of a capital nature.
Another way of determining the taxability of court-awarded damages is to consider the nature and the type of contractual right which has been breached. If the contract being breached is a standard contract normally entered into in the course of business, such as for the supply of goods or services, the breach in such contracts would generally be revenue in nature and taxable.
However, if the contract is in relation to the profit-earning structure of the business, such as a long-term distribution contract, the damages awarded for such breach in contracts potentially be of a capital nature. There are many other factors to be considered in determining the taxability of such court-awarded damages.
It is important to understand that court could award a sum which consists of various matters, such as damages, late payment interest, compensation for legal fees incurred, allocatur fees, etc. The tax treatment for each item awarded will be different needs to be assessed separately.
How about the payer?
Whether or not court-awarded damages are taxed in the hands of the recipient is irrelevant to the payer. For the payer, a similar analysis needs to be made to determine whether such payments are capital or revenue in nature. If it is determined that the damage is revenue expenditure, another condition that needs to be met is whether such expenses are wholly and exclusively incurred in the course of producing the income.
For example, if the contract is in relation to the business, such as liquidated damages for a contractor or a property developer, then normally such damages paid would be a deductible expense for the business.
It is important for businesses to consider the implications of both paying and receiving any court-awarded damages as the sums awarded are usually significant, and if the tax treatment is not correctly adopted, the resulting tax adjustments and penalties will also be considerable.
This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai (www.thannees.com).
