The Supreme Court held in ScottishPower that there is no policy-based, judge-made rule that penalties and fines are not deductible. The reason they are not deductible is simply that such expenditure is not incurred for the purposes of the trade but is incurred because the taxpayer had a liability under the regulatory regime to pay them. The Supreme Court extended the same reasoning to payments made instead of penalties which could not be regarded as “voluntary” because if they had not been made, penalties of a similar amount would have been imposed.

On this basis, the Supreme Court unanimously overturned the Court of Appeal’s decision and restored the Upper Tribunal’s decision that none of the payments in question are deductible expenses for corporation tax purposes. This is a significant win for HMRC both in this case and in other cases where companies reach a settlement with a regulator to make redress payments for regulatory infringements instead of paying comparable penalties.

What were the details of the settlements?

The taxpayers carried on energy supply businesses. Settlements were made in connection with investigations by the energy regulator, GEMA, into regulatory breaches by the taxpayers. The settlements totalled around £28 million and comprised a number of payments (Redress Payments) to consumers, consumer groups and charities and a number of nominal £1 financial penalties. The First-tier Tribunal (FTT) had concluded that, had the Redress Payments not been made, it was likely that penalties of the same amount would have been imposed.

Why are penalties not deductible?

The Supreme Court considered why penalties imposed on a taxpayer are not deductible expenses and whether the Redress Payments made instead of penalties should also not be deductible.

The Court of Appeal had decided that expenditure to meet fines or penalties may be expenditure incurred for the purposes of the trade but a judge-made rule prevented them from being deductible for policy reasons and that such a rule could not be extended to payments instead of penalties. The Supreme Court concluded that the Court of Appeal had misread the reasoning of Lord Hoffmann in McKnight v Sheppard. There is no judge-made rule that penalties and fines are not deductible. According to the Supreme Court, the reason they are not deductible is that such payments are not incurred for the purposes of the trade as a matter of statutory construction of the legislation (which is now section 54(1)(a) CTA 2009).

The purpose of the taxpayer in making the payment is key to the test in section 54(1)(a). The Supreme Court concluded that the purpose of the taxpayer in making a penalty payment is “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”. This is not itself a purpose of the trade.

Should payments made in lieu of penalties be treated in the same way as penalties? 

Although the taxpayers described the Redress Payments as voluntary, the Supreme Court did not accept this characterisation. SPERL, the holder of the energy supply licences, was not compelled to enter into the settlement agreements, but if it had not done so, the taxpayers would have faced fines of similar amounts. On this basis, the Supreme Court concluded that looking at the substance rather than the form, the Redress Payments were akin to penalties and governed by the same principles and therefore not deductible.

What about the Redress Payments to consumers directly affected by mis-selling?

The FTT had concluded that payments of some £554,000 made to consumers directly affected by mis-selling infringements were deductible on the basis they were compensatory and “akin to damages for breach of a tortious obligation not to mislead them”. The Supreme Court agreed with the Upper Tribunal’s decision that it was not right to treat this payment differently from the other sums. The £554,000 formed part of the overall negotiated package and was as much a punishment for the breaches of the regulatory conditions as the other sums. The result was that the whole package was not deductible.

What are the possible implications for other taxpayers?

In ScottishPower, regulatory breaches had been established and, without the Redress Payments, penalties of a similar magnitude would have been imposed. The Supreme Court therefore treated the payments as akin to penalties. The position may be different where a settlement is reached before any breach is established and expressly involves no admission of liability, although the character of the payments and the taxpayer’s purpose in making them, viewed in the context of the settlement as a whole, will remain important. This may be a moot point, however, as we are aware that at least one regulatory authority has, since the Court of Appeal’s judgment, required a commitment by the payer to not take a tax deduction for the payments as part of the settlement agreement.