Deductibility of redress payments?

The debate over the deductibility of payments made in the context of settling regulatory investigations in ScottishPower SCPL Ltd v HMRC continues to raise fundamental questions of how a taxpayer’s trading profits should be determined for tax purposes – with varying conclusions reached at every stage so far. The recently published decision of the Court of Appeal represents an important win for the taxpayer, with potentially broad implications.

It is relatively easy to identify case law demonstrating that at least some penalties are non-deductible; it is rather harder to extract from that case law principles capable of explaining why this should be so in a way which makes sense of all the authorities. Lord Hoffmann famously attempted the feat in the decision of the House of Lords in McKnight v Sheppard [1999] 1 WLR 1333, but the intended meaning of key aspects of his explanation has itself simply become part of the conundrum.

The Court of Appeal considered two ways in which a disallowance of penalties could be justified:

• The first was to say that penalties belong to that small category of costs which are inherently incapable of being incurred ‘for the purposes of the trade’ and so are necessarily disallowable under the ‘wholly and exclusively’ rule. (Other well-known examples of costs of this kind being the costs of ceasing to trade, or corporation tax itself.); and
• The second was to say that there exists a ‘judge-made’ rule of law (identified in cases such as CIR v Alexander von Glehn & Co Ltd [1920] 2 KB 553) requiring certain penalties to be disallowed.

The Upper Tribunal preferred the first of these approaches, but the Court of Appeal has concluded that it is the second approach which is correct.

That conclusion will potentially create further questions. Although the authorities are clear that it is possible for judge-made rules to require adjustments in calculating taxable profits, they are at the same time sceptical as to whether such rules exist in practice. It will be interesting to see whether the Court’s readiness to apply judge made rules precisely in this case prompts any further attempts to ground non-statutory adjustments to trading profits in the early case law in this area.

The immediate consequence of the Court of Appeal’s approach was that the scope of the judge made rule needed to be inferred from the earlier case law (notably, von Glehn), taking account of the requirement not to usurp Parliament’s role in establishing the law. This meant that:

• The application of the judge made rule requiring penalties to be disallowed to non-statutory penalties was less clear. However, the Court did indicate that no authority was cited for the proposition that the deductibility of a payment should be determined by reference to the nature of the payment which it replaces. The Court said that, outside of fines and penalties imposed under a statutory regime, it is necessary to consider whether the payment actually made is deductible, applying the usual principles. Prior to the decision it was generally accepted that non-statutory penalties (for example, those imposed under certain non-statutory regulatory regimes) were non-deductible, but it seems likely that the Court’s comments on the point will now reopen that debate; and
• The judge made rule could only be regarded as applying to penalties and not to amounts paid as an alternative to penalties. The Court accepted that it was therefore open to a taxpayer faced with the threat of non-deductible penalties to negotiate a settlement under which it instead paid amounts that were not penalties and hence attracted tax relief. Any concerns that this raised were, the Court considered, ultimately ones for Parliament to address if it wished.

Applying this approach to the facts of the case, the Court agreed with the taxpayer that (aside from a nominal £1 payment) no part of the settlement package it had entered into with the regulator involved the payment of a penalty, and hence this was fully deductible.

That conclusion is in stark contrast to the decision of the Upper Tribunal (which had held that the payments were all disallowable) and the First-tier Tribunal (which had held that they were mostly disallowable). This, coupled with the broader implications of the analysis underpinning the Court’s analysis, suggests that HMRC may well consider a further appeal. Even in the absence of a further appeal, the decision opens the door to challenge the deductibility of non-statutory penalties and redress payments.

Taxpayers should review any such payment which has been made in an open corporation tax period, or within the last four years, and consider whether claims (including claims for overpayment relief) should now be made. Due to time limits, it is critical that such action is taken promptly.

For further information please contact:

• Paul Freeman
• Angela Savin