Now the taxman's after your pay-out

Thousands of victims of financial mis-selling will be forced to pay tax on their compensation payments, it was revealed this week.

In a stark warning, the Inland Revenue said successful claims would be liable for tax where part of the award was compensation for loss of interest.

For instance, with-profit bond mis-selling victims, many of whom saw their income cut, or their capital largely disappear, are often compensated for loss of interest. A large element of their compensation will be based on the interest they would have enjoyed from putting their cash in a deposit account.

Endowment victims have, in some cases, been made awards for loss of interest and they could also face a nasty tax bill.

Many insurers have been deducting tax at source to satisfy the tax rules. Norwich Union says it applies the 20% standard savings tax rate to all claims where part of the award was for loss of interest. However, the Association of British Insurers admits some insurers rely on customers to make their payments.

Critics say the Inland Revenue's decision to tax a portion of compensation awards contradicts the spirit of the compensation rules set up by the government. They also say the arrangements are flawed and should be reviewed before any further tax deductions are made.

Chas Roy-Chowdhury of the Association of Chartered Certified Accountants, says: "The idea of trying to capture tax on this money after the event, is unacceptable. Many people have suffered severe financial hardship and risked losing their homes as a result of financial mis-selling.

"It is also highly probable that many of those have already allocated most of the compensation received to repay the huge deficits in their mortgages. The Revenue should draw a line under this issue and make such compensation payouts exempt."

Tim Moore, co-founder of EndowmentClaims.biz, a no-win, no-fee compensation claims firm, said it was possible many endowment victims were higher rate taxpayers and could be forced to pay 40%, even though the gains on endowment policies are only ever charged at the standard rate. He says: "We are therefore urgently seeking clarification on this matter from the Financial Ombudsman Service, and will be taking it up on our clients' behalf where appropriate.

"In cases where the person being compensated is in a higher tax bracket, they have good grounds for claiming additional compensation to cover any such tax liability."

Mr Roy-Chowdhury says the interest payments could also relate to several years, or even decades. "The customers would have paid the tax each year, but now they must pay on one lump sum, and may even be pushed into the higher tax bracket because of it."

The Inland Revenue says the rules have been in place for some time and the publication of its tax bulletin, which seeks to clarify the situation, only confirms existing rules. The bulletin says that while pension mis-selling pay-outs and awards for personal injury are exempt from tax (in the case of pension mis- selling because it is specifically protected in the 1996 Pension Act) all other forms of compensation could be liable for tax.

It says: "While detailed approaches (of insurers) may vary, we understand that the broad aim of compensation payments is to put investors back in the position they would have been in had they not bought, or put money into, the product.

"One way of doing this is to refund the premiums (or other amounts) paid by the investor, together with an additional amount to compensate for the time he or she did not have use of the money.

"Where this is adopted, we consider there can be little doubt that the additional payment is interest."

However, insurance experts said the vast majority of endowment awards qualified as "ex-gratia" payments and were not liable for tax. A spokesman for Norwich Union said most cases of compensation that included interest payments concerned with-profit bonds.

Mr Moore said many of the claims handled by his firm included interest payments and clients had been forced to declare the interest element to the tax authorities.

"In our experience it is usually when someone has hung on to the policy thinking they need to keep it to make a claim. When they win their award they are compensated for the two or three years when they could have done something more profitable with the monthly payments," he says.

He urged mis-selling victims who received awards to check whether interest was included and whether tax has already been deducted.