Don't Forget The Tax (Tax on Damages in Commercial Litigation)
- Arnold Shields
- Jun 30, 2011
- 3 min read
Updated: Jun 12, 2025
When damages are awarded as compensation for lost profits, they are generally taxable in the year they are received. This applies whether the award is treated as:
Ordinary income under section 6-5 of the Income Tax Assessment Act 1997, or
Statutory income under sections 15-30 or 70-115 of the same Act【Note 1】.
However, determining the correct amount of compensation involves more than a simple calculation. If the lost profits would have been taxed had they been earned, the compensation must reflect after-tax profit, not gross earnings.
The Gourley Principle and Tax Deduction
In Cullen v Trappell (1980) 29 ALR 1, the High Court confirmed that compensation for lost profits must deduct tax to reflect net economic loss. This is known as the Gourley Principle【Note 2】.
Why a Gross-Up Adjustment Might Be Required
To fully restore the claimant to their original position, damages may require a "gross-up" for tax. This ensures that the compensation isn't effectively taxed twice — once by adjusting for lost net profits, and again when the amount is assessed as income on receipt【Note 3】.
When Tax Complexity Arises
Some claims are presented before tax, often for simplicity. This occurs frequently in trust structures where beneficiaries and their tax positions vary. However, several scenarios demand careful tax consideration:
1. Varying Tax Rates Across Claim Periods
When claims span multiple financial years, the applicable tax rates may differ. For example:
Corporate tax rates changed in the early 2000s.
Future projected losses may not match current tax rates.
This makes applying a uniform tax rate inappropriate.
2. Timing Differences and Cash Flows
Tax laws distinguish between income and deductible expenses. Simply applying a tax rate to net cash flows can misrepresent the true tax impact, especially when large capital expenditures are involved, which may not be deductible in full in the year incurred.
3. Interest on Damages and Over-Claims
Many claims include interest calculated under Supreme Court rules. If tax isn’t considered in the core claim, the interest component can be significantly overstated.
4. Tax Losses Arising from the Cause of Action
Where a dispute or breach causes a tax loss, this benefit must be factored into the calculation — especially if a gross-up is being applied.
When Compensation May Not Be Taxable
Some types of compensation may fall outside the income tax net altogether. For instance:
Personal injury claims (including defamation awards to companies) are considered capital and are exempt from capital gains tax (CGT) under section 118-37(1) of the Income Tax Assessment Act 1997【Note 5】.
Out-of-court settlements may attract CGT if they cannot be clearly separated into income and capital components.
Account of profits awards (e.g. for patent infringement) may be treated as capital in nature, but still subject to CGT — though this area remains uncertain in Australian law【Note 4】【Note 6】.
Why This Matters in Litigation and Settlement Negotiations
If the tax consequences of a damages award are ignored:
The claimant may be undercompensated (or overcompensated) depending on how the claim is taxed.
Settlements may inadvertently create unexpected tax liabilities if income and capital components are not clearly defined.
A well-constructed claim should mirror real-world tax outcomes to pass judicial scrutiny and reduce exposure to reassessment or clawbacks.
Need Help with Tax on Damages or Settlement Amounts?
At Dolman Bateman, we specialise in calculating damages with the correct tax treatment and gross-up adjustments, particularly for complex cases involving trusts, intellectual property, and commercial disputes.
📞 Call us on (02) 9411 5422 to discuss your matter in confidence.
Notes & Authorities
Income Tax Assessment Act 1997, ss 6-5, 15-30, 70-115
Cullen v Trappell (1980) 29 ALR 1 – confirmation of the Gourley Principle
Gill v Australian Wheat Board (1980) 2 NSWLR 795
Commissioner of Taxation v Sydney Refractive Surgery Centre Pty Ltd (2008) FCAFC 190
Income Tax Assessment Act 1997, s 118-37(1)
Taxation Ruling TR95/35 – guidance on CGT for compensation payments.
Disclaimer:
The information provided in this article is general in nature and does not constitute personal financial, legal or tax advice. While every effort has been made to ensure the accuracy of this content at the time of publication, tax laws and regulations may change, and individual circumstances vary. Dolman Bateman accepts no responsibility or liability for any loss or damage incurred as a result of acting on or relying upon any of the information contained herein. You should seek professional advice tailored to your specific situation before making any financial or tax decision.
