Now taxman wants a slice of mis-selling payouts

The government is facing a row over revelations that the Inland Revenue is charging tax on some compensation payments made to victims of financial mis-selling.

Nearly £1 billion has been awarded to victims of endowment mis-selling and millions more are due to people caught up in other financial scandals such as mis-selling of split capital investment trusts.

Endowments were sold as tax-free products but the Inland Revenue has confirmed that where part of the compensation payment is interest - representing returns that would have been earned on capital had the investor not put the money into the mis-sold product - people will be taxed at their highest rate of income tax.

In the case of endowments, where the average compensation payment has been about £1,600, if the interest element was £600 a basic rate taxpayer would owe £120 and a higher rate taxpayer £240. There are no figures available on how many compensation payments have included interest, or how much.

The financial ombudsman and the Financial Services Authority say a minority of people are affected. The ombudsman says interest is usually payable only to people who have surrendered their policies. In some cases endowment companies may have paid the bills. The FSA and the Inland Revenue says that compensation claimants should contact their tax offices if they need help.

The FSA is to issue a state ment this week in an attempt to clarify the position. But John Whiting, a partner with the accountant PricewaterhouseCoopers, said that the only answer is for the government to exempt mis-selling payments from tax.

Legislation was passed during the Nineties to exempt pensions mis-selling compen sation from tax and Whiting and others believe the government should do the same for other mis-selling victims.

The Liberal Democrat treasury spokesman, Vincent Cable, has written to the Inland Revenue asking it to justify its position. In his letter he described the Revenue's position as 'highly inequitable and arbitrary'.

'Surely the test should be that taxation should be no higher [or less] than if the financial products had matured in the normal way.'

Whiting said he would be asking the Chartered Institute of Taxation to raise the issue with the government.