Supreme Court finds redress payments non-deductible

Why are penalties non-deductible?

It is uncontroversial that at least some ‘penalties’ are non-deductible for tax purposes; however, the case law in this area has historically been less clear on the rationale behind this.

In the earlier stages of ScottishPower, having reviewed the earlier case law, the Upper Tribunal held that penalties (understood broadly as costs incurred by the taxpayer as a punishment) were disallowable as they were inherently incapable of meeting the requirement to be incurred ‘wholly and exclusively for the purposes of the trade’. The Court of Appeal took an alternative view that the case law identified a ‘judge-made’ rule of law had been established, requiring penalties imposed by a statutory regime to be disallowed.

Importantly, the former interpretation favoured by the Upper Tribunal covered all situations where the taxpayer was being ‘punished’ (whether through the imposition of statutory penalties or otherwise) whereas the latter left room for debate over whether payments other than actual statutory penalties should be disallowable at all.

Settling the debate, the Supreme Court has sided with the Upper Tribunal explaining at [86] that a taxpayer’s ‘purpose’ in paying a penalty is invariably a non-trading one. It is not concerned with the earning of profits in the trade but rather “to satisfy a legal obligation which arises usually under statute to punish the taxpayer for infringing rules which bind him in the conduct of his trade”.

The Supreme Court concluded that no additional judge-made rule exists to preclude relief for penalties. This is consistent with the Supreme Court’s decision in NCL Investments v HMRC [2022] UKSC 9 which, despite acknowledging that it was possible that judge-made rules could exist, expressed scepticism about them.

What is a ‘penalty’?

The Supreme Court described penalties in this context at [81] as being “punishments imposed because of wrongs the taxpayer has committed” with the object of both punishing the taxpayer and deterring such behaviour by others. The Supreme Court specifically distinguished penalties in this context from ‘tortious damages’.

Although the redress payments in this case were made voluntarily by the taxpayer, the Supreme Court noted that they were made to avoid fines of the same or similar amounts and therefore, in substance, the payments were held to be akin to penalties. This included a payment to compensate customers, which the taxpayer argued was akin to tortious damages. On the facts of the case, this was held to be part of the overall package punishing the taxpayer for the regulatory breaches. It was clear, in the Supreme Court’s view, that if the redress payments had not been made, statutory penalties would have been imposed.

The Supreme Court acknowledged that, in other cases, there could be a difficult dividing line between payments at the close of an investigation and earlier expenditure to pre-empt or appease a regulator (for example the costs of taking pre-emptive steps to remedy issues ahead of an investigation concluding). It is therefore unlikely that the Supreme Court’s intervention will mean the end of disputes over whether redress costs incurred by regulated businesses are deductible.

For further information please contact:

• Lee Ellis
• Paul Freeman