Tax in quantification of damages – Barclay v Road Accident Fund [2012] (3) SA 94 (WCC)

The decision of the Cape High Court in Barclay v Road Accident Fund [2012] (3) SA 94 (WCC) concerns the question whether, in quantifying damages for loss of earning capacity, the amount to be awarded to the claimant should be reduced to take account of the income tax that would have been payable if the claimant had received the amount by way of ordinary earnings, rather than as a lump-sum award of damages.

This is an issue on which courts around the world have been unable to reach a consensus. The landmark decision in this regard is the House of Lords decision in British Transport Commission v Gourley [1955] 3 All ER 796 (HL) which held that income tax must be deducted from the claimant’s notional earnings in quantifying the loss of earnings.

The Gourley judgment was followed by the Australian High Court in Cullen v Trappel [1980] HCA 10 ((1980) 146 CLR 1). By contrast, the Canadian Supreme Court in R v Jennings et al supra [1966] SCR 532, has declined to follow the Gourley judgment and has held that the income tax that a claimant would have had to pay on future earnings should not be taken into account when quantifying the damages payable for loss of earning capacity.

The Gourley decision has, in the past, been applied in several South African decisions, and it is therefore significant that, in the present case, the Cape High Court declined to do so. The court held, instead, that tax should not be deducted in quantifying the claimant’s loss of earnings, either in the first stage of computing the notional loss of earnings, nor in the second step of quantifying the notional rate of return on the invested amount.

 

Fundamental fiscal principles In the present case, the court laid the groundwork for its decision by articulating the underlying fundamental principles, namely –

  • prior to the coming into force of capital gains tax in South Africa, receipts of a capital nature were not subject to income tax,
  • a distinction must be drawn between a claim for loss of earnings as distinct from a claim for the loss of earning capacity – an amount in respect of the former is of a revenue nature and in respect of the latter, of a capital nature, and
  • an award of damages, in the hands of the recipient takes on the character of the loss in respect of which it was paid; thus, if the payment is in respect of a loss of a capital nature, the award is similarly of a capital nature, but if the payment is in respect of a loss of income, the award is of a revenue nature.

A two-stage calculation The judgment goes on to make the point (at para [18]) that the actuarial calculation of damages for loss of earning capacity has two stages: in the first stage, there is a determination of the notional income that the claimant would have earned over the relevant period; in the second stage, this amount is capitalised at a net discount rate that takes into account the rate of return at which it is assumed that the claimant would have invested the lump sum and the likely future rate of inflation.

The imposition of income tax potentially impacts on both stages of the calculation. In the first stage, the question is whether income tax should be deducted in calculating the claimant’s gross notional earnings over the relevant period. (If income tax were taken into account, the notional earnings over the period would be reduced by the amount of tax payable.) In the second stage of the calculation, the question is whether income tax should be taken into account in quantifying the net discount rate. (If income tax were taken into account in this stage of the calculation, the result would be a lower net discount rate.)

The decision of the court In his judgment in the present case, Blignault J said (at para [20]) that in principle it would be unfair to a claimant if income tax were to be deducted from his gross notional earnings and if a pre-tax investment rate were then used in calculating the net discount rate; this, he said, would amount to imposing double taxation on the claimant. After discussing overseas judgments, Blignault J held (at para [32]) that, in the matter before him, income tax should not be deducted in the first stage of calculating the claimant’s gross notional earnings.

He went on to hold that, in the second stage, it would in principle be unfair to the defendant if an after-tax investment rate were to be used in the calculation. However, he said, there was no reason in principle to make the assumption that the claimant would invest the award in such a manner that the proceeds were fully taxable. The claimant might, for example, invest the amount awarded by purchasing capital assets; moreover, the claimant would be in a position to choose between various available investments, and some of them may yield a tax-free return.

Blignault J said (at para [39]) that, in order to avoid subjecting the parties in the present matter to yet another round of evidence and argument, he proposed to award a sum which, on the evidence, would be reasonable compensation for the plaintiff’s partial loss of earning capacity, and in that regard he would assume that the plaintiff was likely to invest a substantial portion of the sum in tax-free investments. On that basis, Blignault J awarded a sum of R500 000.

The impact of this judgment This judgment, whilst not binding outside the Cape, is nonetheless significant in adding to the division of opinion in High Court judgments in South Africa as to whether the Gourley principle should or should not be applied in quantifying a claim for loss of earning capacity.

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