Court of Appeal clarifies approach to tax deductibility of regulatory breach payments

Jake Landman and Sam Wardleworth were commenting after the Court of Appeal ruled in favour of ScottishPower in a case against HM Revenue and Customs (HMRC). 

Landman said: “The Court of Appeal’s judgment is very clear and appears to be the correct approach. The basis on which HMRC had succeeded before the Upper Tribunal created practical difficulties when attempting to apply it to various possible scenarios.”

The case (20 pages/290 KB) revolved around payments made by ScottishPower to settle various regulatory investigations conducted by the Office of Gas and Electricity Markets (Ofgem). As part of the settlements, ScottishPower agreed to pay nominal penalties of £1 and, as well as having made significant improvements to its internal processes, to make substantial redress payments totalling several million pounds to impacted customers and charities.

ScottishPower sought to deduct these redress payments for corporation tax purposes, on the basis that they were incurred wholly and exclusively for the purposes of its trade. However, HMRC denied the deductions, contending that the payments were in lieu of penalties and therefore not deductible under established legal principles.

The First-tier tax tribunal (FTT) found that most of the payments were non-deductible, apart from the small proportion that had been made directly to certain customers which were compensatory in nature. The Upper Tribunal then dismissed ScottishPower’s appeal and allowed HMRC’s cross-appeal, meaning that all the redress payments were non-deductible. ScottishPower appealed to the Court of Appeal and succeeded on all payments.

The Court of Appeal considered that previous case law had established a rule that a deduction will be denied for expenditure on fines and penalties that have been imposed under a legislative regime. This applies even if those expenses were incurred wholly and exclusively for the purposes of the trade and taken into account in calculating profits in accordance with generally accepted accounting practice. However, that rule does not extend to amounts that are not in fact fines or penalties.

HMRC’s argument – that the amounts of the redress payments should be treated as having the same character as a penalty because they replaced possible statutory penalties – was dismissed. This was because no authority for the proposition was available and the scope of such a rule was very difficult to define. The regulatory authority imposing the fine, or agreeing not to do so in return for some other settlement, could take tax relief into account in that agreement and there is no need for the courts to step in to alter that position.

HMRC’s interpretation would also require a focus on the intentions of the party imposing the penalty or agreeing to a settlement – for instance, Ofgem in this case. On the other hand, the statutory test, under section 54 of the Corporation Tax Act 2009, focuses on the intention of the person making the payment, for example whether the expenditure was incurred for the purposes of the trade of ScottishPower.

The FTT had already found as a matter of fact that the redress payments were incurred wholly and exclusively for the purposes of the trade and had been deducted in calculating profits in accordance with generally accepted accounting principles (GAAP). This conclusion was not being challenged or disturbed on appeal. In the absence of a principle that required settlement payments to be treated as if they were penalties, all of the payments in question would therefore be deductible.

“It is possible that HMRC may attempt to appeal to the Supreme Court, but it will need to obtain permission, and the Court of Appeal judgment is robust,” said Landman.