Tax deductibility and illegality

Introduction

You may recently have read reports to the effect that tax experts have expressed the view that expenses incurred by the Post Office in settling compensation claims brought by former sub-postmasters (and sub-mistresses) are not deductible because the expenses in question arise from unlawful conduct on the part of the Post Office. The purpose of this article is not to consider whether those tax experts are right, let alone whether the Post Office is indeed guilty of any unlawful conduct (I do not have enough information to be able to comment on either of those issues) but only to discuss the applicable principles, which apply to all types of wrongdoing, whether civil or criminal.

Wholly and exclusively for the purposes of the trade

The starting point, of course, is that by virtue of s.54 CTA 2009 (for corporation tax) and s.34 ITTOIA 2005 (for income tax), expenses incurred by a trader are not deductible in calculating the profits of the trade unless they are incurred “wholly and exclusively for the purposes of the trade”.?

As the Court of Appeal explained in Vodafone Cellular v Shaw [1997] 69 TC 376, in order to determine whether an expense is incurred wholly and exclusively for the purposes of the trade, two questions must be answered by the fact-finding tribunal. The first question involves identifying the purposes for which the expense was incurred: this is a subjective question which requires the tribunal to look into the mind of the trader at the time when the expense is incurred in order to identify the trader’s purpose or purposes in incurring it. The second question involves ascertaining the character of that purpose or purposes: this is an objective question, in that the characterisation of the trader’s purpose as a trade or non-trade purpose is a matter for the tribunal, not the trader.??

This article will focus on the second, characterisation, question in the context of unlawful conduct: that is, in what circumstances does the fact that the trader’s conduct was unlawful mean that the purpose of incurring an expense must be characterised as a non-trade purpose? In short, in what circumstances can it be said that unlawful conduct is not within the scope of the trade?

Statutory prohibitions

Before embarking on this discussion, it should perhaps be mentioned that by virtue of s.1304 CTA 2009 (for corporation tax) and s.55 ITTOIA 2005 (for income tax) no deduction is allowed for expenses incurred in making a payment if the making of the payment constitutes a criminal offence (or would do so if it were paid in the UK). For example, a dealer in illegal drugs cannot deduct the cost of buying their trading stock.

So far as I am aware, however, that statutory rule has no application to the compensatory payments and associated payments of legal costs made by the Post Office, and so I will not consider it any further.?????

Fines and penalties

The next point to make is that expenditure incurred by a trader in satisfying a liability to pay a fine or penalty, or in settling a claim for payment of a penalty or fine, must be regarded as having a non-trade purpose. As Lord Hoffmann explained in McKnight v Sheppard [1999] 1 WLR 1333, if the fine or penalty were deductible then the public policy of penalising the trader would be diluted, and part of the cost of the penalty would be borne by the general body of taxpayers, which Parliament cannot have intended.

As the recent decision of the UT in Scottish Power v HMRC [2023] UKUT 218 illustrates, this is an inflexible rule of public policy which applies to any payment made in satisfaction or settlement of what in substance is designed to penalise, whether called a fine or penalty or not, and also applies even if the liability arises as a regular and almost unavoidable incident of the trade.

However, that particular public policy rule applies only to the fine or penalty itself. It does not apply to prohibit the deduction of legal costs incurred by the trader in unsuccessfully disputing liability to the fine or penalty, as in McKnight v Sheppard itself.

Still less does that rule apply to expenditure in satisfying a claim which is compensatory rather than punitive in nature, such as damages for loss suffered as a result of a defamatory article published by a newspaper company, as in The Herald and Weekly Times Ltd v FCT [1932] 48 CLR 113. In that case, the court held that such claims against the newspaper company were a regular and almost unavoidable incident of publishing the newspaper, and therefore expenditure incurred in meeting the claims was within the scope of the trade and must be characterised as having a trade purpose.

It follows, in my view, that the public policy rule has no application to the compensatory payments made by the Post Office to former sub-postmasters, and to the associated payments of legal costs.

Unlawfulness of itself is not necessarily a bar to deduction

In the light of the above, we can say that provided always that the trader’s expense does not consist of a payment the making of which is a criminal offence, and also does not consist of satisfying liability to pay, or settling a claim for, a fine or penalty, the fact that the expense arises out of unlawful conduct on the trader’s part is not, of itself a necessary bar to deduction. This is self-evidently the case where the conduct involves a mere civil wrong, such as negligence or a breach of contract.

But it is also the case, in my view, where the conduct involves the commission of a criminal offence. For example, in IRC v Alexander Von Glehn & Co Ltd [1920] 2 KB 553, the taxpayer company traded with a German company during WW1, thereby breaching the Customs (War Powers) Act 1915, and so became liable to a penalty. The penalty was held not to be deductible, but this was not because trading with the German company was characterised as not being within the scope of the trade. On the contrary, as Lord Sterndale MR put it, “during the course of the trading the company committed a breach of the law”.

Nor does is matter that the criminal conduct is also morally wrong. For example, in Commissioner of Taxation v La Rosa [2003] FCA FC 125, an Australian case, a drug dealer claimed a deduction in respect of money stolen from him in the course of a drug deal. The Revenue argued that the loss was not deductible in computing the dealer’s profits because the activity was illegal, but the court disagreed. Hely J. commented that a professional assassin can deduct the cost of the bullets and depreciate the cost of his gun, because purchasing them is part of his trade, and it is for Parliament to refuse to permit a deduction of those costs (as indeed the Australian Parliament did shortly after the decision in La Rosa), not for the courts to do so on the ground that the costs are not incurred in the course of the trade.

McLaren Racing

In HMRC v McLaren Racing [2014] UKUT 269, the UT remarked that “a deliberate activity which is contrary to contractual obligations and the rules and obligations governing the conduct of the trade, which is not an unavoidable consequence of carrying on a trade and which could lead to the destruction of the trade is not an activity carried on in the course of that trade”.

This remark was an obiter dictum because, as the UT itself noted, the taxpayer company did not contend that the activity in question was within the scope of its trade.

In my view, the UT’s remark should not be interpreted as purporting to lay down any rule of law. First, because the courts have no power to do so. Secondly, because the UT’s remark was made, and should be understood, in the context of the particular facts of the case.

In that case, the taxpayer company carried on the trade of Formula 1 racing pursuant to an agreement, called the Concorde Agreement, which provided for the exploitation of commercial activities in relation to Formula 1 and thereby generated income for those involved. Under the Agreement, Formula 1 teams agreed to abide by the International Sporting Code (“ISC”) rules, and in return the ISC licensed them to participate in motor sports competitions such as the Formula 1 championship. The ISC rules provided for penalties for breach, including expulsion, which would lead to inability to compete, and therefore destruction of the trade. Thus, the taxpayer company’s trade was defined and governed by the ISC rules: the continued ability to generate income from Formula 1 racing, and therefore the very existence of the trade, was dependent on compliance with those rules. In those circumstances, the UT’s remark that a deliberate and avoidable breach of those rules was not done in the course of the trade makes complete sense.

Phone hacking

Readers will no doubt recall that many civil damages claims have been brought against some newspaper publishing companies, who have incurred very large sums in investigating, defending and settling those claims. Could HMRC argue, in reliance on the McLaren Racing case, that those expenses are not deductible because phone hacking was not only a civil wrong, but was also a breach of the PCC Code and a criminal offence punishable with imprisonment, and therefore must have been outside the scope of the companies’ trades?

In his sentencing remarks in R v Coulson, Saunders J. said that phone hacking was carried out in an increasingly competitive market where whoever got the best stories and created the biggest headlines would sell the most newspapers, so that editors put pressure on journalists to get stories for publication with little concern for how they got them, and as a result a culture of illegal information access (including covert surveillance, going though rubbish bins, and “blagging”, as well as phone hacking) was deployed in order to produce stories for publication.

In the light of that factual background, in my view, it is clearly arguable that phone hacking, although unlawful, was not outside the scope of the trade.

In particular, first, it was not one-off or extraordinary conduct. On the contrary, it was a prolonged and long-standing means of obtaining information for publication in the newspaper which was approved by the editor as being necessary in order to maintain a competitive edge.

Secondly, although phone hacking was in breach of the PCC Code and the general law, the companies’ trades were not defined and governed by a set of rules the breach of which could lead to expulsion from the activity of publishing newspapers and therefore destruction of the trade.

Thirdly, I do not think that conduct can be regarded as outside the scope of a trade merely because, viewed objectively, it puts the existence of the trade at risk. For example, consider a professional gambler who regularly places very high stakes such that a run of bad luck may well lead to his insolvency and the destruction of the trade. It could not possibly be argued that placing such stakes is outside the scope of the trade: on the contrary, that is the very nature of his trade. Thus, whether conduct is outside the scope of a trade depends on the context of the particular trade.??

In this connection, although the News of the World eventually ceased publication, this was not an inevitable or even probable consequence of phone hacking; after all, The Mirror continues to be published. Moreover, as Saunders J’s sentencing remarks indicate, editors judged at the time that hacking was beneficial, indeed, necessary, to the trade, and I do not consider that determining the scope of the trade involves HMRC or the FTT second guessing that judgment.

Finally, as already explained above, the mere fact that phone hacking was unlawful does not, of itself, prevent it being within the scope of the trade. The unlawfulness is a potentially relevant factor, but it is not determinative.

It might be argued that this analysis cannot be correct because it means that if a reporter were, for example, to threaten to beat someone up unless he provides information, that too would be within the scope of the trade, which is absurd. In my view, however, whether the making of such a threat is within the scope of a trade depends on the context of the trade: if the threat is a one-off, extraordinary, unauthorised act of a single rogue reporter, it may well be regarded as outside the scope of the trade, but in the context of a trade where the making of such threats is a widespread and approved practice, the result may well be different. (Of course, a payment made to a professional hoodlum to carry out the threat would not be deductible if the making of the payment is a criminal offence.)

HMRC’s published practice

At BIM38525 HMRC assert that costs arising from a breach of the law, and costs incurred to settle an action alleging a breach of the law, are not allowable. For the reasons given above, in my view that is not correct.

HMRC rely for this proposition on Cattermole v Borax & Chemicals Ltd [1949] 31 TC 202 but that was just about the non-deductibility of a payment made to settle a penalty claim.

At BIM38530 HMRC assert that the costs of civil damages arising as a result of “normal” trading operations are generally allowable, but civil damages arising outside the “normal” course of the trade are not allowable. In my view, this too is not correct: an expense is deductible if it arises from conduct which is within the scope of the trade, whether that conduct is “normal” or not. I would agree that the “normality” or otherwise of conduct is relevant in determining whether it is within the scope of the trade (that is why an unlawful act is more likely to be regarded as outside the scope of the trade if it is a one-off or extraordinary).

HMRC rely for this proposition on Fairrie v Hall [1947] 28 TC 200 but that was a case about duality of purpose: the taxpayer brought a libel action against a trade rival; his legal costs were not deductible because he had a non-trade purpose (the libel action was malicious) as well as a trade purpose.??

Conclusion

The deductibility of the payments made by the Post Office by way of compensation and associated legal costs does not turn on whether its conduct giving rise to the compensation claims was unlawful (and I emphasise that I do not know whether it was unlawful or not). In particular, the unlawfulness of the conduct cannot of itself mean that it falls outside the scope of the Post Office’s trade.??