When are penalty payments deductible for tax purposes?
Upper Tribunal clarifies the principles governing the deductibility of fines and penalties
UT explains non-deductibility of penalties
That ‘penalties’ are non-deductible for tax purposes is non-controversial, but why this is the case and what counts as a penalty in this context has been hotly debated. The Upper Tribunal’s decision in ScottishPower (SCPL) Ltd and others v HMRC [2023] UKUT 218 (TCC), dealing with the deductibility of various payments made under voluntary settlement agreements with the energy regulator, represents the latest attempt to clarify the underlying principles. Previous cases have demonstrated the importance of correctly understanding these principles in any situation in which the taxpayer may be seen as being punished (making these relevant well beyond the regulated sector in view here). The decision will therefore be valuable reading for anybody concerned with these issues.
Discussions around the deductibility of ‘penalties’ and similar payments have a tendency to morph into a debate over the interpretation and significance of the decision of the House of Lords in McKnight v Sheppard [1999] UKHL 6. In that case, Lord Hoffmann endeavored to briefly articulate the relevant principles in a way which made sense of a seemingly conflicting body of existing case law. But do those comments remain authoritative and what exactly was Lord Hoffmann trying to say? Those were the issues at the heart of the present appeal.
Over the years, it has occasionally been suggested that Lord Hoffmann was identifying a judge-made rule of law that limited tax relief for certain penalty payments. The problem with that, as the taxpayer here rightly pointed out, is that (as noted in a previous edition of Tax Matters Digest) the Supreme Court’s decision in NCL Investments has cast serious doubt over the ongoing validity of this kind of judge-made rule.
Justifying its conclusion that McKnight continues to be relevant, the Upper Tribunal set out its view that far from expounding a judge-made rule of law, Lord Hoffmann was simply addressing the prohibition (now in s 54 Corporation Tax Act 2009) on deductions not incurred wholly and exclusively for the purposes of the trade concerned and explaining what is meant by ‘the purposes of the trade’ in this context.
On the interpretation now laid down by the Upper Tribunal, it appears that McKnight should be understood as simply clarifying that if the nature of a particular payment is that of a penalty, then it cannot be said to have been incurred for the purposes of a trade.
This, of course, begs the question as to what exactly it means for a payment to have the ‘nature of a penalty’?
In the Upper Tribunal’s view, the answer to be derived from McKnight was, in essence, simply that the payment must be punitive in character.
This meant, for example, that the Upper Tribunal agreed with the First-tier Tribunal that payments made in lieu of a penalty as part of a voluntary settlement could in some cases have the necessary nature of a penalty. What mattered was simply whether, in substance, the payments had a punitive nature or character rather than whether they were described as penalties as a matter of legal form.
Similarly, the Upper Tribunal rejected the view that Lord Hoffmann could be taken to have laid down additional tests which needed to be met before a payment that was punitive in nature would be disallowed; for example, that the payments must not be a regular and/or almost unavoidable incident of carrying on the trade or not be compensatory in nature. Although Lord Hoffmann had indeed referred to these factors (in agreeing with the decision of the High Court of Australia in Herald & Weekly Times Ltd v Federal Commissioner of Taxation [1932] HCA 56 that the damages for defamation payable by the newspaper in that case were deductible), this was simply by way of explaining why, viewed in the round, the payments in that case were not considered punitive in nature.
A corollary of this was that the Upper Tribunal agreed with HMRC that the First-tier Tribunal had been wrong to treat an element of the settlement payment as deductible on the grounds that it was intended to be compensatory. The relevant payment formed part of a package of payments, the whole of which had been agreed in lieu of a penalty and been found by the First-tier Tribunal to be punitive in character. It followed that all the payments were non-deductible, regardless of whether some also had characteristics of compensation.
It is not yet known whether there is to be a further appeal.
